[Senate Hearing 112-238]
[From the U.S. Government Publishing Office]
S. Hrg. 112-238
ENHANCED INVESTOR PROTECTION AFTER THE FINANCIAL CRISIS
=======================================================================
HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
ON
SURVEYING THE INVESTOR PROTECTION PROVISIONS CONTAINED IN THE DODD-
FRANK WALL STREET REFORM AND CONSUMER PROTECTION ACT ONE YEAR AFTER ITS
IMPLEMENTATION
__________
JULY 12, 2011
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Charles Yi, Chief Counsel
Dean Shahinian, Senior Counsel
Laura Swanson, Policy Director
Levon Bagramian, Legislative Assistant
Andrew Olmem, Republican Chief Counsel
Hester Peirce, Republican Senior Counsel
Michael Piwowar, Republican Senior Economist
Dawn Ratliff, Chief Clerk
William Fields, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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TUESDAY, JULY 12, 2011
Page
Opening statement of Chairman Johnson............................ 1
Opening statements, comments, or prepared statements of:
Senator Shelby............................................... 2
WITNESSES
David Massey, NASAA President and North Carolina Deputy
Securities Administrator....................................... 3
Prepared statement........................................... 33
Response to written questions of:
Senator Moran............................................ 85
Lynnette Hotchkiss, Executive Director, Municipal Securities
Rulemaking Board............................................... 5
Prepared statement........................................... 37
Response to written questions of:
Senator Reed............................................. 87
Harvey L. Pitt, Former Chairman, Securities and Exchange
Commission..................................................... 6
Prepared Statement........................................... 48
Barbara Roper, Director of Investor Protection, Consumer
Federation of America.......................................... 9
Prepared Statement........................................... 55
Response to written questions of:
Senator Reed............................................. 89
Senator Menendez......................................... 92
Anne Simpson, Senior Portfolio Manager, Global Equities,
California Public Employees' Retirement System................. 10
Prepared Statement........................................... 66
Response to written questions of:
Senator Shelby........................................... 93
Senator Hagan............................................ 94
Paul S. Atkins, Visiting Scholar, American Enterprise Institute
for Public Policy Research..................................... 12
Prepared Statement........................................... 71
Response to written question of:
Chairman Johnson......................................... 94
Lynn E. Turner, Former Chief Accountant, Securities and Exchange
Commission..................................................... 14
Prepared Statement........................................... 78
Additional Material Supplied for the Record
Prepared statement of the American Bankers Association, the
Financial Services Roundtable, Financial Services Institute,
Insured Retirement Institute, and National Association of
Insurance and Financial Advisors............................... 97
Prepared statement of the Center on Executive Compensation....... 111
ENHANCED INVESTOR PROTECTION AFTER THE FINANCIAL CRISIS
----------
TUESDAY, JULY 12, 2011
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met at 10:02 a.m. in room SD-538, Dirksen
Senate Office Building, Hon. Tim Johnson, Chairman of the
Committee, presiding.
OPENING STATEMENT OF CHAIRMAN TIM JOHNSON
Chairman Johnson. The Committee will come to order.
Today, the Committee will examine ``Enhanced Investor
Protection After the Financial Crisis.'' This hearing will
survey the investor protection provisions contained in the
Dodd-Frank Wall Street Reform and Consumer Protection Act as we
approach its 1-year anniversary.
About one-half of American households are invested in the
securities markets, directly or indirectly. During the
financial crisis, retail as well as institutional investors
suffered financial harm when their retirement and other
securities accounts lost value. Some had invested in companies
with compensation systems that encouraged executives to take on
unmanageable risks. Some had bought asset-backed securities
based on inflated credit ratings. Many were victims of the
market decline when the public lost confidence in the markets
and their regulators.
This last financial crisis highlighted the need for
stronger investor protections to mitigate the negative impact
of future crises.
Congress responded by passing the Wall Street Reform Act,
which contains robust investor protection provisions and other
new reforms. These provisions sought to strengthen the
financial system by improving the accuracy of credit ratings,
better aligning the economic interests of securitizers and
investors, boosting the effectiveness of the SEC, giving
shareholders a greater voice over compensation, regulating
municipal advisors and hedge fund advisors, and encouraging
credible whistleblowers to come forward and report fraud and
abuse by providing them enhanced protections and incentives.
As we approach this 1-year anniversary, it is timely for us
to survey investor protection provisions in the Wall Street
Reform Act, many of which are still in the process of being
finalized. While some have criticized reforming Wall Street, I
believe we must give these provisions a chance to work to
protect investors and American families who depend on our
financial system.
I remember the economic nightmare we lived though 3 years
ago and am proud that the Senate could act to pass these
historic reforms last year. I take my responsibility as
Chairman of the Banking Committee to oversee implementation of
this new law seriously and look forward to hearing from the
witnesses about these investor protections.
Now I will turn to Ranking Member Shelby.
STATEMENT OF SENATOR RICHARD C. SHELBY
Senator Shelby. Thank you, Mr. Chairman. Thank you for
calling this hearing.
Mr. Chairman, I noted with interest we have the former
Chairman, Mr. Harvey Pitt, among the panelists--all of them are
welcome--and also Paul Atkins, former Commissioner. A good
panel.
The title of today's hearing is ``Enhanced Investor
Protection After the Financial Crisis.'' The reality, however,
is that the passage of Dodd-Frank did little to improve
investor protection. Instead, the act codifies a series of
special interest provisions of questionable value to the
average investor. In fact, several of these provisions threaten
to harm investors.
For example, under the proxy access provision, the SEC
adopted a rule that would grant shareholders with a mere 3
percent of a company's shares the special right to have their
board of director nominees include in a company's proxy
material. Three percent.
Special interest groups, like unions, State pension funds,
and hedge funds will now have the leverage to force companies
to adopt politically motivated agendas, regardless of whether
doing so would benefit all shareholders.
As a result, Dodd-Frank's corporate governance provisions
could move control of corporations away from average investors
to special interests with minority positions and political
clout.
Another troubling Dodd-Frank provision is that the mandate
that the SEC pay whistleblowers. Although encouraging people to
inform the SEC of corporate misdeeds I believe is a good idea,
the whistleblower provision in Dodd-Frank is drafted in a way
that could actually harm investors. Whistleblowers, even those
who are part of the scheme, will receive 10 to 30 percent of
fines that the SEC collects as a result of their tips. Rewards
in a single case could run into tens of millions of dollars.
This will be a huge windfall for whistleblowers and their
attorneys. It would also be far in excess of the amount needed,
I believe, to encourage whistleblowers.
Recent history has demonstrated that the problem has not
been a lack of tips but, rather, the SEC's failure to follow up
on tips. Perhaps the millions that will go to whistleblowers
under Dodd-Frank should be redirected to harmed investors.
Finally, the Dodd-Frank's mandated internal changes at the
SEC I believe are symbolic of the Act's empty promise of
investor protection. Dodd-Frank requires the SEC to set up an
Office of Investor Advocate and an Ombudsman for that office.
Think about it. The SEC is supposed to be the investor's
advocate already and has an Office of Investor Education and
Advocacy. Adding another two layers of bureaucracy I believe is
not the kind of help that investors need.
It is now 1 year since the passage of Dodd-Frank, and we
can see more clearly the consequences of a special interest
agenda. The Act, I believe, again, has not helped investors but
has saddled Main Street and providers of capital--the engines
of economic growth, in other words--with a long list of new
regulatory requirements and more to come. At a time when the
unemployment rate is at 9.2 percent, this hardly seems like a
wise course to me.
Thank you, Mr. Chairman.
Chairman Johnson. Are there any other Members who wish to
speak? If not, we are fortunate to have a distinguished panel
of regulators and experts before the Committee today.
Mr. David Massey is the President of the North American
Securities Administrators Association. Mr. Massey is also the
Deputy Securities Administrator of North Carolina Securities
Division and serves as a member of the Financial Stability
Oversight Council.
Ms. Lynnette Hotchkiss is the Executive Director of the
Malpractice Securities Rulemaking Board, a self-regulatory
organization whose mission is to promote a fair and efficient
municipal securities market.
Mr. Harvey Pitt is currently the Chief Executive Officer of
the consulting firm Kalorama Partners. Previously he served as
the Chairman of the SEC from 2001 to 2003.
Ms. Barbara Roper is the Director of Investor Protection at
the Consumer Federation of America and has in the past served
as a member of the Investor Advisory Committee at the SEC.
Ms. Anne Simpson is Senior Portfolio Manager at the
California Public Employees' Retirement System, where she heads
the corporate governance program.
Mr. Paul Atkins is a Visiting Fellow at the American
Enterprise Institute. From 2002 to 2008 he served as a
Commissioner at the SEC.
Our final witness is Mr. Lynn Turner. In addition to his
decades of experience in the accounting field, from 1998 to
2001 he served as the Chief Accountant at the SEC.
I would like to welcome our witnesses and thank them for
their willingness to testify at this important hearing.
Mr. Massey, please proceed with your testimony.
STATEMENT OF DAVID MASSEY, NASAA PRESIDENT AND NORTH CAROLINA
DEPUTY SECURITIES ADMINISTRATOR
Mr. Massey. Good morning, Chairman Johnson, Ranking Member
Shelby, and Members of the Committee. I am David Massey, the
Deputy Securities Administrator for the State of North Carolina
and the current President of the North American Securities
Administrators Association, known as NASAA. Thank you for the
opportunity to offer NASAA's view of the gains made in investor
protection since the passage of the Dodd-Frank Act 1 year ago.
The Wall Street reforms and investor protections in Dodd-
Frank Act were born out of necessity. The financial crisis made
it clear that the existing securities regulatory landscape
needed an overhaul.
This comprehensive law was developed to promote stronger
investor protection and more effective oversight to help
prevent another economic crisis from threatening the financial
security of Main Street investors. State securities regulators
were pleased that the Dodd-Frank Act addresses a number of
critical issues for investors by incorporating disqualification
provisions to prevent people who violate securities law from
selling unregistered securities offerings under Rule 506 of
Regulation D, by strengthening the ``accredited investor''
definition, and by increasing State oversight of investment
advisors. Dodd-Frank also includes a provision to safeguard
senior investors from unqualified advisors and creates an
investor advisory committee to provide input to the SEC on its
regulatory priorities.
Dodd-Frank took a necessary first step toward reducing
risks for investors in unregistered private offerings by
requiring the SEC to write rules to prevent known offenders
from using the Regulation D, Rule 506 exemption from
registration. In 1996, the National Securities Markets
Improvement Act curtailed the authority of State securities
regulators to oversee these unregistered private offerings
before and while they are being sold to the public.
In the years since, these private offerings have become a
favorite vehicle for unscrupulous promoters and brokers with
criminal and disciplinary records to prey on investors. The SEC
recently proposed rules mandated by Dodd-Frank to close this
avenue to known violators of our securities laws.
Unregistered private offerings were originally intended
only for institutional investors and sophisticated individuals.
These accredited investors were presumed capable of assessing
risks and making investment decisions without the protection of
regulatory review and registration. However, the net worth
standard the SEC uses to determine the eligibility of an
investor to participate in private offerings has remained
unchanged since 1982. Dodd-Frank improved the way eligibility
is determined by excluding the value of individual investors'
homes in the calculation of their net worth.
NASAA will continue to push for additional improvements to
the accredited investor standard, and we urge Congress to go
further by reinstating State regulatory authority and oversight
of all Rule 506 offerings.
Dodd-Frank recognized the strong investor protection record
of the States with its provision to expand State authority to
include mid-sized investor advisors with $25 million to $100
million in assets under their management. Investors will
benefit from this change because it will enable the SEC to
focus on the largest investment advisors while mid-sized and
smaller advisors will be subject to the strong State system of
oversight and regulation.
State securities regulators are preparing for this
increased responsibility. We now employ a more automated and
uniform exam process as well as risk assessment analyses to
better prioritize our exams. This enables States to do more
intelligent and effective exams.
Finally, NASAA members have launched an aggressive outreach
effort to prepare the investment advisor industry for State
oversight and to enable new registrants to set up their
business operations the correct way and avoid inadvertent
noncompliance.
Last month, the SEC extended its timeline for the
completion of this investment advisor switch into the middle of
2012. Dodd-Frank outlined many ambitious reforms to be
implemented by Federal regulatory agencies. Some delay is to be
expected. However, State securities regulators are concerned
about any effort that might derail or delay important investor
protections. A lack of adequate funding already has forced the
SEC to defer a number of valuable investor protections promised
by Dodd-Frank, such as the creation of the Investor Advisory
Committee.
Also, controversies over the Consumer Financial Protection
Bureau have indefinitely delayed the creation of a senior
investor protection grant program that would support State
initiatives to protect vulnerable senior investors from
individuals using misleading professional designations.
What NASAA asks of the Congress is simple and clear: Please
continue your commitment to protecting investors and do not
weaken the critical investor protections of Dodd-Frank, either
directly through legislative repeals or indirectly through a
lack of adequate funding.
We look forward to working with the Committee, as well as
all Members of Congress and fellow regulators, to ensure that
the Dodd-Frank Act's investor protections are implemented
fully.
Thank you.
Chairman Johnson. Thank you, Mr. Massey.
Ms. Lynnette Hotchkiss, please proceed.
STATEMENT OF LYNNETTE HOTCHKISS, EXECUTIVE DIRECTOR, MUNICIPAL
SECURITIES RULEMAKING BOARD
Ms. Hotchkiss. Good morning, Chairman Johnson, Ranking
Member Shelby, and Members of the Committee. I appreciate the
opportunity to testify here this morning on behalf of the
Municipal Securities Rulemaking Board.
Congress created the MSRB in 1975 to protect investors in
the municipal market, and last year, in Dodd-Frank, you
expanded our jurisdiction to include the protection of State
and local government bond issuers as well as public pension
plans. To the best of our knowledge, this is the first time
ever that a securities regulator has been charged with
protecting an issuer of securities. You also gave us
jurisdiction to regulate municipal advisors in addition to our
existing jurisdiction over dealers in this market. We
appreciate the opportunity to report to you today on how we
have responded to these increased responsibilities.
As you can see from the chart, the municipal securities
market makes up just over $3.7 trillion of the total U.S. debt
market. Additionally, about $150 billion is invested in 529
college savings plans, another kind of municipal securities
which fall under our jurisdiction.
The second chart shows how the $382 billion of municipal
securities issued since the enactment of Dodd-Frank last July
are being used. It is hard to imagine a street, airport,
school, park, or town hall in this country not financed through
the issuance of municipal securities, and I do not need to tell
those of you who have served in State or local office just how
important the municipal bond market is to the continued health
and vitality of our States, cities, towns, schools, and
universities.
Like every market, transparency and disclosure are critical
to investing protectors. Our free online resource called EMMA
does exactly that. As you can see, EMMA provides investors with
free access to disclosures and pricing data, information they
need to make informed investment decisions. An example of
information on EMMA from a recent issuance in your respective
States is included with my written testimony.
In fact, a journalist from Reuters reported just last week
that, and I quote, ``Since the Municipal Securities Rulemaking
Board made their EMMA system operational, transparency in muni
land is an order of magnitude better than any other bond
market.''
Because retail accounts for two-thirds of all investors and
over 80 percent of all customer transactions in municipal
securities, we designed our EMMA system to be easily usable by
the general public.
The MSRB has undertaken other substantial initiatives to
protect investors. We are in the process of implementing a
Federal fiduciary duty standard, additional restrictions on
``pay to play'' activities, and mandated disclosures of all
conflicts of interest. These are described in detail in my
written testimony.
In Dodd-Frank, Congress gave the MSRB the authority to
regulate municipal advisors and swap advisors. Mr. Chairman, as
you and Ranking Member Shelby are well aware, the events of
Jefferson County, Alabama, made it very clear that vast
improvement in the municipal derivatives market was needed, and
the MSRB has already taken significant steps in this area:
first, by ensuring that State and local governments are given
impartial professional advice by qualified advisors; and,
second, by ensuring that underwriters that recommend swaps
explain in clear language all of the risks attendant to that
transaction.
In a similar way, our expanded authority allows us to
further protect investors in competitive bidding situations.
Just last week, the SEC and the Department of Justice announced
settlements with JPMorgan Securities in connection with bid
rigging. Earlier this year, UBS and Bank of America Securities
entered into similar agreements.
Until now, the SEC could only address this egregious
behavior through its anti-fraud jurisdiction. But now, under
recent initiatives of the MSRB, such conduct would be a clear
violation of our fair dealing and fiduciary duty rules,
providing additional fire power to the SEC to go after these
wrongdoers.
The MSRB is dedicated to ensuring that the municipal market
regulations we promulgate and the transparency afforded by our
EMMA system promote an open, fair, and efficient market, one
that protects issuers and investors alike, and one that
continues to fund the critical public infrastructure needs of
our country.
Thank you again for the invitation to testify, and I look
forward to any questions that you might have.
Chairman Johnson. Thank you, Ms. Hotchkiss.
Mr. Pitt, please proceed.
STATEMENT OF HARVEY L. PITT, FORMER CHAIRMAN, SECURITIES AND
EXCHANGE COMMISSION
Mr. Pitt. Good morning, Chairman Johnson, Ranking Member
Shelby, Members of the Committee. I am pleased to be back
before you today to respond to the Committee's invitation to
testify about the critical issue of ``Enhanced Investor
Protection After the Financial Crisis.''
The Committee has specifically requested that today's
testimony focus on Titles IV and IX of the Dodd-Frank Act and
the extent to which those provisions enhance investor
protection or could be improved.
I would like to highlight five overarching observations
about Dodd-Frank in Titles IV and IX from my written statement
for your consideration.
First, the financial crisis that began in 2007-08 was the
product of the failure of our outmoded and cumbersome financial
regulatory system and the lack of adequate tools that would
have enabled regulators to respond effectively, efficiently,
and with alacrity both to the warning signs that a crisis was
imminent and to what eventually became a full-blown crisis. I
believe that Dodd-Frank unfortunately represents a missed
opportunity to fix that which was clearly broken and to provide
a better arsenal of regulatory rules to detect and cope with
the next financial crisis, which sadly is not all that far
away.
Instead of producing a more nimble regulatory regime, we
have saddled regulators with a more cumbersome regulatory
system that almost ensures that we will not be any better
equipped to respond to future financial and capital markets
developments than we were for this last crisis. And, worse, we
have created the possibility that the independence of three
critical financial regulators--the Federal Reserve Board, the
SEC, and the CFTC--will be impaired by subjecting these
agencies to the dictates of the new Financial Stability
Oversight Council that is led by the Treasury Secretary and,
therefore, must be responsive to policies pushed by whatever
Administration is in power at that particular time.
Second, I am deeply concerned that Dodd-Frank sets
financial regulators, and particularly the SEC, up for failure.
The SEC has been saddled with extensive new regulatory
obligations, but has been denied the necessary resources with
which to fulfill those obligations. In particular, the Act
imposes or expands SEC jurisdiction and oversight over more
than 10,000 new and potential regulatees. Despite the agency's
good-faith and diligent efforts, the public will be lulled into
believing that we have solved the problems that caused our most
recent economic collapse. But in my view, Dodd-Frank represents
only the triumph of optimism over decades of hard-learned,
real-world experience.
Third, Dodd-Frank tackles significant and difficult issues
of corporate governance in awkward and potentially pernicious
ways. Among such provisions, Dodd-Frank's whistleblower bounty
program threatens to undermine corporate governance and
compliance programs by encouraging potential whistleblowers to
evade internal corporate policies and ethical precepts in order
to maximize the potential lucre these whistleblowers may demand
from the SEC. Similarly, the Act's say-on-pay provisions have
usurped the proper province of State corporation laws and
potentially subject shareholders to a steady stream of
frivolous litigation, which has already begun, designed to
force those companies whose shareholders object to specific
compensation programs into treating what was intended as an
advisory expression of shareholder sentiment into a binding
declaration that potentially any corporate officer's or
director's compensation package is too high.
Equally troublesome is the approach toward proxy access
that Dodd-Frank has encouraged the SEC to adopt. The solution
to proxy access issues, in my view, is to permit proxies to be
solicited electronically rather than by snail-mailed hard copy.
That simple change would reduce rather dramatically the current
fervor with which corporate shareholder activists seek to
append their agendas and proposals onto management's proxy-
soliciting materials.
But even in the absence of such a change, the easiest
solution to the so-called proxy access issue is to permit
shareholders to amend their companies' by-laws to the extent
such power is granted under the law of the State of
incorporation by whatever majority vote State law requires. All
the SEC would need do in such an environment is prescribe the
disclosures that must be made as well as the length of time and
the number of shares any shareholder must hold the company's
securities to entitle any shareholder to propose a by-law
amendment.
Fourth, Dodd-Frank imposes upon the SEC a new Office of the
Investor Advocate, a position clearly designed to permit a non-
Presidential appointee to second-guess, challenge, and attack
virtually any action or any inaction of the Commission with
which the Investor Advocate disagrees. Investor advocacy is one
of the two critical objectives of the SEC, the other being to
facilitate the development of effective capital markets that
can compete with markets anywhere in the world. Creating a
special position whose principal function apparently will be to
harangue the Commission without any censorship of any kind,
including rational and intelligent common sense, is something
that can create the seeds of further SEC dysfunctionality.
Fifth, there are ways to ameliorate Dodd-Frank's unintended
consequences, but they require this Committee to approach this
legislation in a nonpartisan and evenhanded manner. Among other
things that should be considered are: mandating the development
of an independent compliance audit process, akin to the
financial audit process that currently exists; ensuring that
the SEC has appropriate resources to fulfill its new compliance
examination and broad regulatory oversight responsibilities;
extending the existing deadlines for SEC rulemaking beyond
their current artificial and often impossible dates; and
providing a better means for the Government to assess the true
costs and benefits of each of the hundreds of new regulations
that Dodd-Frank requires.
Dodd-Frank was intended to address laudable goals.
Unfortunately, it creates perverse incentives that will likely
undermine the intended benefits to investors. With care and a
bipartisan effort, the Act can be tailored so that it more
likely accommodates its original objectives.
Thank you again for the invitation to appear here, and I
will be happy to respond to any questions the Committee Members
may have.
Chairman Johnson. Thank you, Mr. Pitt.
Ms. Roper, please proceed.
STATEMENT OF BARBARA ROPER, DIRECTOR OF INVESTOR PROTECTION,
CONSUMER FEDERATION OF AMERICA
Ms. Roper. Good morning, Chairman Johnson, Ranking Member
Shelby, and Members of the Committee. I appreciate the
invitation to appear before you today.
Improving protections for average investors has been a
priority for CFA for roughly a quarter-century. The issue has
taken on new urgency, however, in the wake of a devastating
financial crisis that has left average investors, American
investors, as fearful for their financial security as the
events of September 11 left them fearful for their physical
safety.
Among the lesser known achievements of the Dodd-Frank Act
is its creation of a multi-faceted investor protection
framework that, if properly and effectively implemented, could
significantly improve regulation of the securities markets and
with it protection of investors. My written testimony discusses
a broad range of the Act's investor protection provisions. In
my oral testimony, however, I focus on just a couple of the
bill's provisions, starting with its provisions to strengthen
credit rating agency regulation.
Before the crisis, the entire system of regulating asset-
backed securities was built on the assumption that credit
rating agencies could reliably assess the risks associated with
these complex and opaque investments, an assumption that proved
to be disastrously misguided. Title IX of the Dodd-Frank Act
seeks to address this fundamental weakness in the regulatory
system with a package of measures designed to make credit
ratings more reliable.
Among the most important are provisions to improve the
SEC's oversight of ratings agencies, to strengthen the agency
ratings agencies' internal controls over the rating process, to
make the assumptions behind the ratings more transparent to
users of those ratings, to hold rating agencies legally
accountable for following sound procedures, and to reduce
regulatory reliance on ratings. Implementation of these
provisions is still a work in progress and we would simply note
that, with the major ratings agencies still subject to massive
conflicts of interest, a lot hinges on the SEC's ability to
provide tough and effective oversight.
The Act also includes provisions addressing more generic
weaknesses in securities regulation, and among these are
provisions designed to provide investors with greater input
into the SEC's policymaking process by creating a potentially
powerful new Office of Investor Advocate within the SEC and
establishing a permanent Investor Advisory Committee. I think
it will come as no surprise that I view these provisions very
differently than former Chairman Pitt.
Some question the need for these provisions because the SEC
is supposedly the investor advocate, but it is not. Its job is
to protect investors, which is different from advocating for
investors. And the simple fact is that investors lack the
organization, manpower, and resources to monitor agency actions
and effectively interact with SEC leaders and staff. As a
result, the agency's agenda is often developed and specific
proposals to implement that agenda are developed with minimal
impact for investors, at least until the public comment
process, while industry is involved at every step of the
process. Once the Office of Investor Advocate and the Advisory
Committee are up and running, investors should benefit from an
agency that is more attuned and responsive to their concerns.
Another set of little noticed provisions in the bill have
the potential to transform the disclosures retail investors
rely on in making investment decisions. The Act requires the
SEC to identify ways to improve the timing, content, and format
of disclosures. It authorizes the agency to engage in investor
testing of new and existing disclosures to ensure their
effectiveness. And it authorizes the agency to require pre-sale
disclosures with regard to investment products and services.
Together, these provisions give the agency the tools and
authority it needs to develop disclosure documents that are
more timely, relevant, and comprehensible to retail investors.
All of the many investor protection provisions in the Act
will depend for their effectiveness on the SEC's receiving the
funding necessary to carry them out. Unfortunately, after three
decades in which our securities markets experienced explosive
growth in size, complexity, technological sophistication, and
international reach, the SEC today is critically underfunded
and understaffed to carry out its existing responsibilities,
let alone take on the vast new responsibilities entrusted to it
in Dodd-Frank.
Congress attempted to address this problem in Dodd-Frank by
authorizing funding increases that would roughly double the
agency budget by 2015. Unfortunately, the debates over the
fiscal year 2011 and 2012 budgets have already made clear that
turning those authorizations into appropriations is going to be
a tough fight, and we appreciate the leadership that you,
Chairman Johnson, and Members of this Committee have played in
fighting for that full SEC funding. While we are sympathetic to
those who argue that money alone cannot solve all the agency's
problems, we also believe that without additional funding, the
agency cannot reasonably be expected to effectively fulfill its
investor protection mission.
In conclusion, the investor protection framework provided
in Dodd-Frank is a sound one, but it only takes us so far. For
it to succeed, regulators will have to demonstrate a
willingness to use their authority aggressively and
effectively, and Congress will have to provide them with both
the resources and the backing to enable them to do so.
Chairman Johnson. Thank you, Ms. Roper.
Ms. Simpson.
STATEMENT OF ANNE SIMPSON, SENIOR PORTFOLIO MANAGER, GLOBAL
EQUITIES, CALIFORNIA PUBLIC EMPLOYEES' RETIREMENT SYSTEM
Ms. Simpson. Thank you. Good morning. Chairman Johnson,
Ranking Member Shelby, and Members of the Committee, thank you
very much for the opportunity to come and speak to you this
morning. My name is Anne Simpson. I am Senior Portfolio Manager
in the Global Equity's Division of CalPERS. So my purpose this
morning is really to share with you some practical insight into
how Dodd-Frank is working, emphasize to you how important the
corporate governance provisions are, and if anything, to remind
the Committee that there is still further work to be done.
But let me start at the most important point, which is
explaining something about CalPERS and the size and
significance of our fund in the market. As you will be aware,
CalPERS is the largest public pension fund in the United
States. We have approximately $235 billion in global assets and
our equity holdings extend to something like 9,000 companies
worldwide.
Now, this money is invested for an extremely serious
purpose. We provide retirement benefits to more than 1.6
million public workers, retirees, and their families. And if
you want to think about that in terms of its economic impact,
this year, we will have paid out something in the order of $11
billion in benefits. Seventy cents on every dollar that we pay
out typically comes from investment return. So think of the
number of people reliant on the market through the activities
of our investment fund. This is not a theoretical exercise.
The people that we are investing for, generally, they are
on modest incomes. On average, a CalPERS beneficiary will be
living on benefits from the fund on the order of $2,000 a
month. Today, we have released a report actually looking at the
economic impact through those payments, if you would be
interested in a copy.
So for this reason, we have a very serious fiduciary duty
to pay attention to the safety and soundness of the market, and
this is why corporate governance is, to us, absolutely
fundamental to the security of those returns, which we have to
think about on a risk-adjusted basis over a very long
investment time horizon.
Our size and our very long-term liabilities mean that we
cannot ignore problems in the market. There is no safe place
for CalPERS to go when things go wrong. We are simply too big.
There is not a corner of the stock market where everything is
working wonderfully well and you can talk over $200 billion and
hope these difficulties will somehow go away. So we have been
paying very close attention to Dodd-Frank's reform proposals
and we are also very glad to be working within the new rigor,
the new transparency and accountability that this Act is
providing.
I also would like to draw to your attention that in
addition to the corporate governance reforms, CalPERS has been
actively supportive of other elements of Dodd-Frank, the
proposals around systemic risk oversight, proper funding and
independence for regulators, which has just been touched on,
proper derivatives reform, credit rating agency overhauls, and
consumer protection. We see these as a package of measures that
need to be carefully coordinated. Corporate governance will not
do the job on its own.
So let me then just turn to a number of corporate
governance provisions in Dodd-Frank which we see as
particularly important, and I would be glad in the questions to
explain further why that is so.
I think it is fair to say it is almost commonplace now that
we acknowledge that the financial crisis was fueled by a toxic
combination of lax oversight and misaligned incentives. This is
why governance reform is vital. It is through improved
transparency and accountability that we will be able to address
these sorts of systemic weakness. Too many chief executives
pursued risky strategies or investments that bankrupted their
companies or weakened them financially for years to come, and
we know the knock-on effect in the economy has been devastating
for millions. Boards were often complacent. They were blinded
by group-think, which is also why we regard board divestiture
so important, and unwilling to challenge or rein in reckless
executives who threw caution to the wind. We know that
accountability is critical to motivating people to do a better
job. This is why sound pay is so important.
We also think it is vital that proxy access is finally
introduced in order that we can hold boards to account. Our
significant and most important role is to be able to vote on
the hiring, the firing, and the removal of board directors, and
without proxy access and its companion piece, majority voting,
we are not in a position to do that. We are simply those with
bark but no bite.
Finally, we would like to encourage the further improvement
of disclosure, which Dodd-Frank has begun, notably around
important subjects like board leadership, for example, the
separation of the chairman and the chief executive. And we
welcome the efforts that are being made to give investors the
information they need that is critically important, but also it
is very important that that information can be matched by
appropriate action, which is where proxy access will give us an
extremely useful tool for improving the situation, not just for
the benefit of our beneficiaries, but we think it will have a
systemically useful impact.
Thank you.
Chairman Johnson. Thank you, Ms. Simpson.
Mr. Atkins is a visiting scholar instead of a fellow, as
was said at the beginning of the hearing. I regret that.
STATEMENT OF PAUL S. ATKINS, VISITING SCHOLAR, AMERICAN
ENTERPRISE INSTITUTE FOR PUBLIC POLICY RESEARCH
Mr. Atkins. That is OK. Thank you very much, Mr. Chairman
and Ranking Member Shelby and Members of the Committee for
inviting me to appear today at this hearing.
I come before you today not only as a former Commissioner
of the Securities and Exchange Commission, but also a member of
the former Congressional Oversight Panel for the TARP program
and, of course, as a Visiting Scholar at AEI. It is a privilege
for me to be able to participate in the public discussion about
the issues of the day in the context of my years of work in the
public and private sectors.
The news of this past week has highlighted the
disappointing state of affairs in our economy. The unemployment
rate increased to 9.2 percent while the labor force itself
shrank by more than a quarter of a million people. More than 14
million Americans are out of work, and almost half of those
have been out of work for more than 6 months.
Uncertainty in the legal and regulatory landscape of the
financial services industry is a major cause of why the economy
is doing so poorly, because it discourages investment and
extensions of credit to entrepreneurs. A primary reason for
this uncertainty is Government policy, particularly Dodd-Frank,
which was ostensibly enacted for the sake of market stability
and investor confidence. Because most of the provisions were
not directly related to the underpinnings of the financial
crisis, investors ultimately will pay for the increased costs
associated with the mandates without receiving commensurate
benefits. Further exacerbating uncertainty, legal challenges to
Dodd-Frank and the rules that the various agencies will issue
are inevitable, not just as to the technicalities of the rules
and whether they have been properly promulgated, but also as to
basic questions of jurisdiction and, yes, constitutionality.
As the past year has shown, Dodd-Frank also mandates very
tight deadlines for Federal agencies to draft and implement
these rules. Members of this Committee have been justifiably
concerned that Federal agencies are sacrificing quality for
speed as they neglect to properly weigh the costs and benefits
to the economy of their proposed rules. These are complicated
concepts with huge ramifications and the regulators have got to
get it right.
Today, you have asked specifically that we address Titles
IV and VII of Dodd-Frank. Title IV and the rules that the SEC
adopted effectively force all investment advisors managing more
than $150 million in assets to register with the SEC. Even
advisors to venture capital funds, which Congress specifically
exempted from registration, effectively are caught up in the
SEC's new registration and examination scheme. These rules will
have a multi-pronged effect. They will burden advisors and thus
investors with costs, increasing barriers to entry. They will
strain SEC resources and divert its attentions from protecting
retail investors, which is what its primary focus should be.
And the effect of these two situations will foster a mistaken
sense of security among investors so that they may think that
SEC registration means that they can let their guard down.
Bernie Madoff indicates otherwise.
Now, moving on to Title IX, which encompasses a wide range
of issues, including credit rating agencies, whistleblowing,
fiduciary duties, SEC management, and then a grab-bag of issues
that have been pushed for years by special interest groups of
politicized investors and trial lawyers, I just want to make a
few points in the time remaining.
This Committee took action with respect to the Credit
Rating Agency Reform Act of 2006 to address the troubling
oligopoly of credit rating agencies and the SEC's opaque method
of designating these agencies as nationally recognized
statistical rating organizations. Ultimately, unfortunately,
Dodd-Frank has taken an inconsistent approach with respect to
credit rating agencies. The threats currently being levied by
Government officials in Europe demonstrate that rating agencies
are susceptible to political pressure as to the supposed
correctness of their ratings. Congress should consistently push
transparency, accountability, and competition instead of
Government control and second-guessing of ratings so that
investors can get high quality and objective advice from credit
rating agencies.
Now, with respect to whistleblowers, I agree with the
remarks of Chairman Pitt. Under Section 913, the SEC has
recommended that Congress harmonize a standard of care for
investment advisors and broker-dealers. I think it is important
to remember that not all investors are the same. The standard
of care as has developed over the past 75 years for brokers is
robust and has features that vindicate grievances that are more
streamlined than what investors face in State court with a
fiduciary duty standard. In those cases, the contract rules--
the fine print under the contract, especially.
Some investors perhaps want and need a fiduciary who
possesses intimate knowledge of their financial condition and
can advise them accordingly. On the other hand, some investors
would prefer to have a true broker who is engaged on a
transaction basis and is compensated accordingly. These two
kinds of activities should have different standards of care
attached to them.
Title IX contains many other provisions, most of which have
nothing to do with the causes of the financial crisis, and in
my short window of time today, I cannot discuss all of these
sections, but I do want to make one special plea. I encourage
this Committee to exercise its oversight over SEC management.
Just last week, the SEC Chairman testified about the recent
leasing decision and suggested that the SEC should no longer
have leasing authority. In contrast, last year, some were
suggesting that the SEC should have a self-funding mechanism
outside of the normal Congressional appropriations process.
In the meantime, the SEC has pursued an extremely divisive
agenda marked by more than a dozen three-to-two votes in the
past 2 years alone. I have never witnessed such a division.
This record is in marked contrast to my experience of 10 years
total at the SEC, first as a staffer in two Chairmen's offices
and then as a Commissioner under three Chairmen. The dissenters
today are reasonable people and their dissents are not always
fundamentally opposed to the rulemaking itself. But the sad
fact is that it appears that the leadership of the SEC does not
engage effectively on the finer points of the policy issues.
Thus, I encourage this Committee to continue to exercise
oversight of SEC management.
Thank you.
Chairman Johnson. Thank you, Mr. Atkins.
Mr. Turner.
STATEMENT OF LYNN E. TURNER, FORMER CHIEF ACCOUNTANT,
SECURITIES AND EXCHANGE COMMISSION
Mr. Turner. Thank you, Chairman Johnson and Ranking Member
Shelby. It is always a pleasure and, quite frankly, an honor to
be back here in front of this Committee, and it is especially a
pleasure with our distinguished Senator from Colorado.
I have listened to the comments today and I guess we can
all agree that we do not all agree. But it is fascinating to
me, in light of the fact that here we are, 4 years after the
subprime crisis imploded on us, the worst since the Great
Depression. Investors around the globe lost $28 trillion in the
capital markets in value. That was half of the entire world's
GDP at the time. Ten to 11 trillion was lost here in the United
States, and that does not include the loss in value of their
homes.
People have said Dodd-Frank was the cause of this. Dodd-
Frank was not even passed at the time that this occurred. What
Dodd-Frank tried to deal with was the outcome of that. It was
the crisis that started and caused the lost jobs we have heard
about, tens of millions of lost jobs, lost wages, and lost
homes.
If Congress had not have acted as it did, I believe we
would have been in a Hooveresque-type depression at this point
in time, and it certainly was not brought on by a regulatory
structure that was out of whack, although certainly I think
Dodd-Frank fixed some of the problems that are there, and on
that point, I think I would agree with Harvey that there were
some changes that did need to be made. But it was regulatory
inaction leading up to and throughout the crisis that caused us
problems.
As Dr. Greenspan has noted himself, there were things they
could have done, they had the power to do. Congress had given
them the power. This Banking Committee had given the Fed the
right to regulate those bad loans that were made, and the Fed
chose not to regulate. That is what has caused the unemployment
and jobs, and I congratulate Congress for acting on that.
In my 35 years of experience, though, as a banker, an
auditor, a regulator, investor, and teacher, I have always
found that if you are going to have markets work, they have got
to have five basic fundamental pillars to work. There has got
to be transparency. You have got to have the information you
need to make the investments. You have got to have
accountability, the people who take that money, including the
management teams, the boards, have got to be accountable for
their actions, as do the regulators. It is up to this Committee
to oversee those regulators, and I agree with Paul that good
oversight at the SEC is important. There has to be
independence. The conflicts that we saw at the credit rating
agencies were outrageous and certainly contributed to the
problems. You have got to have effective regulators. And,
finally, you have got to have enforcement of the laws.
Yet, as we look back at the mayhem of this last decade, we
see that there was absolutely a dearth of transparency,
accountability, law enforcement by the regulators and
investors, and regulators alike. No one could decipher the
financial statements from an AIG, a Lehman, a Merrill Lynch.
Assets and capital were inflated, liabilities understated, and
profits upon which huge compensation packages were granted were
a mirage.
So in light of that, in this hearing on Title IX, let me
get back to some of my comments. First of all, the
whistleblower issue. A lot of people have different views on
whistleblowers. Business in general does not like them.
Investors like them. Some people think they go too far. Some do
not. Senator Shelby, you mentioned that they could pay out tens
of millions, and you are absolutely right. But if they are
paying out tens of millions, that means the SEC will have been
imposing fines of $30 to $300 million. That means that you have
got huge financial restatements out there of the like we saw at
WorldCom, where it was restated $11 billion. Those financial
statements were fictional. They were like watching a movie
called ``Fantasia.''
If it is that big, I do want to see that whistleblower come
in and alert the SEC at the earliest possible date. The
Association of Certified Fraud Examiners has shown that it
takes on average 27 months to find a fraud. Why would we not,
in a situation like that, want that tipster to come in at a
much earlier date so people do not have those great big losses
from a WorldCom or an Enron or some of these things we have
seen in the bank.
I have served as an audit committee chair on public
companies overseeing whistleblower and compliance programs. I
think the SEC was very reasonable in their final rulemaking
back in May, and if anything, it is going to result in better
internal compliance and hotlines. They encourage people to go
to the business first, which is good. But 89 percent of the
frauds that the SEC investigated from 1998 to 2007 involved the
CEO and/or CFO at the company. There is a reason whistleblowers
are hesitant, quite frankly, to go to the top. So giving them
the chance to come into the SEC, I think, is great.
Quickly, on proxy access, it was mentioned that just 3
percent. That is actually not correct, because it takes a
majority. All I am asking for investors is give investors the
same right, the owners of the business the same right that the
management team that they have hired has to the proxy to vote
the directors. And it is not 3 percent. The labor unions never
will be able to control this. That is a figment of someone's
imagination, because it takes a majority of the shareholders to
put it through. That is excellent.
As far as the SEC funding, I would just say I totally agree
with Ms. Roper. From 2005 to 2007, the staff of the SEC was cut
by 10 percent. Its spending was cut by $75 million. As a
business executive, I know you cannot shrink to greatness, and
that is what people were trying to do at the SEC leading up to
the subprime crisis.
There was some--I was asked to comment just briefly on
PCAOB and some of the provisions on broker-dealer audits which
the PCAOB is acting on today, very appropriately. We saw from
Madoff that audits of these companies were very poor, the audit
of the assets was very poor, and this provision of the law
helps the PCAOB prevent those type of things, which I think
will be very good as well as work much better with
international regulators.
So I think with that, I will end my comments. But overall,
I think this Title IX of Dodd was well done. Investors did not
get everything they wanted, but, you know, I found that it
would be nice if people in D.C., rather than thinking about
being Democrats or Republicans, started thinking like being
Americans, and I think in Title IX that is exactly what you did
as a Congress and I think that is great. Thank you.
Chairman Johnson. Thank you, Mr. Turner.
I will ask the Clerk to put 5 minutes on the clock.
For any and all witnesses, reflecting on the financial
crisis, what do each of you feel was the most serious harm it
caused to retail and to institutional investors? In reflecting
on the new law, what do you feel are the reforms that will be
most helpful to investors? Mr. Massey.
Mr. Massey. Senator, in my opinion, the most injury from
the perspective that we as State securities regulators see is
with respect to what we call retail investors, also known as
mom-and-pop investors, and these are the people that not only
have taken big hits to their life savings, they have also
suffered impacts on their financial planning that they were
hoping to send their kids to college with. They have lost jobs.
They have lost ownership of their small firms. The landscape is
littered with victims of the financial crisis, and these are
regular people who depended to a great extent for their future
on the integrity of the financial system. Now, when it fell
apart, they took the hit.
Chairman Johnson. Does anyone else care to respond?
Ms. Roper. I would just like to add to that. I think, you
know, there is no question, the financial losses that investors
took were devastating. I think equally devastating is their
loss of confidence in the integrity of the financial system,
their loss of confidence that they can rely on this as a place
to save for retirement, to save for their long-term goals.
And I think one thing that contributes to that is that sort
of a peculiar characteristic of this crisis is that the harm
that flowed to retail investors was not primarily as a result
of anything that was done to them directly. They were not
defrauded by a broker. They are the collateral damage of a
regulatory system of a largely institutional market that simply
did not function. And so they cannot even point to anything
that they did. They followed the rules. They bought and held
and diversified and suffered devastating consequences. So I
think it is that sense in which it undermines their confidence
that they know how to participate safely in these markets and
that their regulators will protect them in the future.
Chairman Johnson. Ms. Simpson.
Ms. Simpson. I would like to answer that. This is Anne
Simpson. In addition to regulators letting people down, let us
shine a spotlight on the shareholder community. That is where
we sit, as CalPERS. The question is, where were the owners? Why
were we not able to see what the problems were as they were
growing? Why were we not able or willing to intervene, to do
something? And it is a simple corporate governance failure in
the market which has left us powerless to behave as responsible
owners.
Think about two parts of the story. The first is majority
voting. This is something which we wanted to come out of Dodd-
Frank and in the end did not survive passage from the early
discussions. This is a situation where, without majority
voting, we cannot remove directors. And second, without proxy
access, we cannot put forward people who we think are better
able to do the job that needs to be done. And if we are not
able to hold boards of directors accountable and regulators are
not in a position to intervene, then, really, this is how you
can have rampant risk running through the system, executive pay
that is out of control, and the situation which really took us
to the brink of the abyss.
Our portfolio was hit to the tune of $70 billion and we are
slowly but surely coming back. But it is extremely important
that in capitalism, and that is the system we are all relying
on, the owners have to be in a position to behave like owners,
and that means being able to hold boards accountable. And if we
are toothless, then I do not see who else can intervene to do
the job.
Chairman Johnson. Mr. Pitt and anybody else on the panel, I
want you to reflect on say-on-pay. In an interview, you were
asked whether say-on-pay is going to be an effective tool to
prevent excesses, to which you replied, ``I think it will be. I
think that this will have a very definite impact on how
corporations and shareholders view these critical issues.''
In your testimony today, you note that say-on-pay would
lead to increased shareholder litigation. Is some litigation,
which you note is finally likely to fail, a necessary
consequence of getting the benefits of say-on-pay? Mr. Pitt and
other panelists, would you comment on this.
Mr. Pitt. Yes. I believe that shareholders have the right
to be fully informed about compensation, and they have the
right to express their views. The difficulty that I see is that
there has evolved a clear trend already on the part of some
lawyers to sue anytime a corporation's shareholders express
disagreement with the compensation levels. So what could have
been an advisory kind of view, which is what the clear intent
of Dodd-Frank was, has now been converted into a litigation
tool, and that costs investors enormous expense. It also
imposes on investors enormous burdens that I think are very
difficult.
I am very much in favor of transparency and having
shareholders have the ability to express whatever views they
have. But I am not in favor of seeing this turned into a
referendum and then a litigation exercise, which appears to be
the direction in which this is headed.
Chairman Johnson. Does anyone else care to comment?
Ms. Simpson. Yes, thank you. CalPERS has voted on 4,000
say-on-pay votes in our U.S. portfolio this year, but we have
been voting on this same issue in Australia, the United
Kingdom, the Netherlands, and Norway for some time. We are a
global player, and I would say that say-on-pay is simply
bringing the United States in line with international best
practice.
We have also found it extremely useful, and the reason is
this: It has meant that companies want to pick up the phone or
answer the phone and talk. They do not want to lose the vote,
they do not want a high level of opposition, and they actually
are being much more attentive to what the owners think, and
this is only proper. Whatever pay is being paid, guess what?
That money is being provided by the shareholders, and it is
only good manners, surely, to be discussing the amounts and the
performance targets.
So we have seen two good things come out of this:
One, the performance periods are getting longer. That is
extremely important because we need to relieve the short-term
pressure on companies, and that in part comes through having
short-term targets for pay.
Second, we have seen a better alignment of pay and
performance, and we have been delighted to see companies filing
amendments to their plans all the way in the run-up to the AGM
deadline. The result of that for CalPERS is that we voted
against 7 percent of the plans that came forward. So we really
see this as a good platform for dialogue, and thank you very
much for the efforts in Dodd-Frank for doing that.
I also forgot to mention earlier the importance of the
claw-back rule in Dodd-Frank. It is extremely important that we
have now clearly got this ability to retrieve ill-gotten gains.
If you know that you cannot get away with it and people will
come after you to turn the money back that you have perhaps bet
your company on a short-term bet and done well yourself
personally, if you know people can come after you and ask for
that money back, I think it concentrates the mind wonderfully.
So thank you for that.
Mr. Atkins. If I could interject one thing.
Chairman Johnson. Yes.
Mr. Atkins. The United States is a lot different than other
countries around the world. Our litigation system and the
shareholder rights system is a lot different. And so I think
the things that Chairman Pitt is pointing out ought to lead to
some caution.
And the other thing that troubles me very much when we talk
about ``investor rights'' is that some owners are treated
differently than others, and the sense that some people can
pick up the phone and talk to and cut back-room deals or
influence things because of their special interest or size I
think is very troubling. And so what we need is more
transparency, and to the extent that these special rules give
certain shareholders more clout than others have I think is a
very troubling development.
Chairman Johnson. Senator Shelby.
Senator Shelby. Thank you, Mr. Chairman.
Mr. Atkins, in the self-funding situation, some
commentators, as you well know as a former Commissioner, have
advocated self-funding for the Securities and Exchange
Commission. Self-funding I believe would make the SEC less
accountable to Congress, and as a former Commissioner, what is
your view about how self-funding for the SEC would change the
incentive perhaps for Commissioners to properly execute their
duties? Would it make them less responsible obviously to
Congress, you know, if they did not have to come before
Congress for an appropriation?
Mr. Atkins. Yes, sir, I think that is a very important
point. I am not in favor of the idea of self-funding. If I were
to put myself in the shoes of you all on the other side of the
table and considering the responsibility to taxpayers, I think
it is incumbent to try to exercise oversight and understand
what is going on: To have various departments and agencies of
the Government go through the normal appropriations process, to
justify their budgets and then make decisions as to who is more
deserving of the capital that is going to be allocated. So, I
think that transparency is very important, and I think it has
done the SEC well over the last decade. Accountability is
crucial.
Senator Shelby. Thank you.
I would like to address this question to the former
Chairman, Mr. Pitt, and also to you, Mr. Atkins, as you both
are former Commissioners of the SEC. Dodd-Frank enacted, as we
all know, a number of changes. We have been talking about
corporate governance. These changes give shareholders with 3-
percent holdings I believe substantially more power than the
average investors. Could these provisions cause companies to
defer to the political or financial agendas of certain special
interest shareholders at the expense of building the company's
value for the benefit of all shareholders? And how do these
changes benefit individual investors if they do? Mr. Pitt,
former Chairman.
Mr. Pitt. Thank you, Senator Shelby. I have a basic concern
with any provision that holds a corporation's shareholders
hostage to the views of special interests with respect to a
company. The ultimate goal of accountability, which is what was
behind these provisions, is a good one, but the solution was
much simpler than the one that the SEC has come up with. The
solution was simply to allow solicitations electronically so
that there would not be the same fervor to make use of
management's proxy materials; and, second, to rely on State
law. The State law determines whether shareholders have the
right to amend their by-laws, and if State law gives
shareholders that right, then they ought to be able to exercise
it subject to restraints on inundating the corporation with too
many proposals and the like.
So I think there is a way to achieve the goal, but it is
not necessarily the one that Dodd-Frank contemplated.
Senator Shelby. Mr. Atkins.
Mr. Atkins. Yes, sir. About 5 years ago, at an SEC
roundtable, in response to a question that I asked, a couple of
witnesses basically admitted that these sorts of provisions add
more arrows to their quiver for them to be able to advance in
smoke-filled rooms--out of sight of the public and without any
transparency--to advance their ulterior motives and their
special agendas. And in the past, State pension funds have also
been basically in cahoots from time to time with some of these
special interests.
So I think that lack of transparency is very troubling, and
for an agency like the SEC, which stands for transparency in
the marketplace, I think that is a troubling development.
Senator Shelby. Mr. Massey, Dodd-Frank shifts the
regulation of certain registered investment advisors from the
SEC to State regulators. Will the State regulators have the
resources and expertise necessary to properly oversee the
investment advisors that would be moved to the States under
their jurisdiction? And how would investors be helped by the
change, if they will?
Mr. Massey. Senator, right now the estimate from the SEC is
that approximately 3,200 investment advisor firms that are
currently federally registered would be shifted over to State
registration and regulation in the so-called investor advisor
switch. NASAA has been preparing for this switch for more than
a year now and has created a number of tools to make the
State's role in regulating these investment advisors much more
intelligent and much more efficient and much more responsive
rather than a rubber stamp type of treatment of the examination
requirement.
We have risk analysis software that is distributed to the
States to let them adjudge the relative risk of the various
firms so they can set their priorities of examination. We have
uniform examination procedures so that every examination is
going to ask the same question of every investment advisor out
there. And, most importantly, the shift has motivated the
States to have an outreach program by which road presentations
are conducted in major cities for not only existing State
registered investor advisors but also Federal advisors that are
coming over, to let the Federal advisors know who the regulator
is, to establish a positive working relationship with the State
regulator, and to set up a good working relationship with what
I refer to as the legitimate side of the industry so that the
local cops on the beat can take their enforcement resources and
put them against the Ponzi scheme operators.
Senator Shelby. Ms. Roper, recently the National
Association of Manufacturers estimated that the new Dodd-Frank
disclosure requirement with respect to conflict minerals, such
as the Congo and so forth, would cost between $9 billion and
$16 billion--in other words, to the industry--rather than the
$46 million that the SEC estimated. Are you concerned at all
that this provision could end up costing investors more than
the benefit that they will receive from disclosure? You know,
we are all interested in doing the right thing, but we are also
interested in some balance of cost here for our manufacturers.
Ms. Roper. We did no work on that provision. I do not know
anything about the provision. I have no basis for analyzing
either of those cost estimates, so I just do not have a basis
for commenting.
Senator Shelby. OK. Ms. Simpson, do you have any knowledge
base on this?
Ms. Simpson. Thank you. Yes, we actually are great fans of
getting all relevant and material information properly provided
to shareholders. But the root is going to be to ensure that,
you know, the costs do not outweigh the benefits. That is a
very sensible point of view.
I have not seen the underlying estimates that you are
referring to, so I cannot comment on that, but it would seem to
me quite extraordinary in this day and age of the Internet that
a company could not find the relevant information in a cheap
and affordable way.
Senator Shelby. OK. Mr. Turner, one last question. In your
testimony here today, among other things, you noted that in the
lead-up to the financial crisis, and I quote, ``most of the
regulators were captured by industry.'' Your words. In your
view, which regulators were captured by industry or are
captured by industry? And if a regulator is captured by
industry, isn't the solution to make the regulator more
accountable to the American people by subjecting the regulators
to more congressional oversight? That is one way, maybe not the
only way. In other words, who was captured by industry?
Mr. Turner. I certainly think the banking regulators were
captured by industry. The Federal Reserve--I have dealt with
the Fed for much of my career, and I think even Dr. Greenspan
has acknowledged, I think, probably the best way to deal with
it is through much greater transparency on the part of the Fed.
I think the SEC in the mid-part of the last decade was
extremely captured by industry, and contrary to what Paul said,
the divisiveness at that point in time o the Commission was
tremendous as well. In fact, I think the current Chairman,
Chairman Schapiro, should be applauded for trying to dial the
tone back a little bit.
But on your point about accountability, I do think both the
Fed and the securities regulator, as well as the CFTC, all of
them need to be subjected to much more rigorous oversight. I
will tell you leading----
Senator Shelby. Like right here.
Mr. Turner. Like right here, Senator. You are absolutely
right. And, in fact, I will tell you that myself and others--
and I think Barb Roper was included in the group at the time.
Just as we were getting into the subprime crisis, probably in
about January of 2007, there was a group of us who came and met
with the Banking Committee staff here as well as the House
Financial Committee staff and members, and we urged at that
point in time much greater, robust, in-depth oversight of the
Commission. And, unfortunately, it did not happen in either
institution.
I will say on the funding issue, I believe you have been
one of the proponents--I have testified before you when you
pleaded with the SEC Chairman to take more funding, and I
greatly applaud you, Senator, for that. We probably disagree on
the issue of self-funding. I am a strong proponent of self-
funding. I think you can self-fund and still do the oversight
hearing. I understand appropriators, people on the
Appropriations Committee, like that oversight, so I understand
where you are coming from.
Senator Shelby. Like the two of us.
[Laughter.]
Mr. Turner. Yes, and I think there is actually----
Senator Shelby. He wants to give up his power. We do not.
Mr. Turner. But I think you could have done it. But, you
know, whether you self-fund or not, the most important thing is
that the money that you scheduled out in Title IX get delivered
to the SEC. And my problem and my concern is if you look at the
first year, 2011, which is $1.3 billion, you are not even
hitting that target. And if you are not even hitting that
target, I have no expectation that you will get the SEC the
funds that it needs. And I think the fact that you saw their
staff cut by 10 percent from 2005 to 2007, $75 million cut in
spending, the management was absolutely atrocious at the agency
at the time, and I would have encouraged you to bring them up,
as we did in January of 2007, and ask them what they were
doing, because they did get the job done. And they did a great
disservice to investors.
Senator Shelby. You are not saying to us today here in the
Banking Committee that the SEC's whole problem or the Federal
Reserve's whole problem--of course, they have no funding
problem.
Mr. Turner. Certainly it was not the Fed because they got
self-funded.
Senator Shelby. It was a lack of money? Or was it a lack of
will and a lack of action and a lack of diligence?
Mr. Turner. I think first and foremost it was a lack of
will and a lack of diligence.
Senator Shelby. Thank you.
Mr. Turner. I think in some cases funding contributed to
that.
Senator Shelby. Thank you, Mr. Chairman.
Chairman Johnson. Senator Reed.
Senator Reed. Thank you, Mr. Chairman, and thank you for
your testimony.
This issue of funding I think is central because Mr. Pitt
expressed a concern I have, that we will give responsibilities
to the SEC and not the resources to get them done, and that
goes for the CFTC also. And so I was a strong proponent of
self-funding even though I am also an appropriator.
I presume, Mr. Pitt, that ultimately you would be
supportive of some type of self-funding mechanism?
Mr. Pitt. Yes. I believe that there are a number of
financial regulators who have the ability to self-fund, and the
SEC should not be a stepchild. I think the concerns that have
been expressed about accountability make it imperative that if
self-funding is granted--and I believe it should be--that there
be complete accountability before the appropriate committees,
this Committee and others, so that you can assess where the SEC
proposes to spend its money. But you would wind up saving
taxpayers a billion plus dollars if the money did not come out
of the Treasury, as it presently does.
Senator Reed. Thank you, Mr. Pitt.
The back and forth has revealed the issue of accountability
as well as funding, and there are ways for accountability. One
is this Committee--in fact, probably a more effective way, if
used correctly, than the Appropriations Committee. But also
there is the issue of regulatory capture, and as you point out,
every other regulatory agency, except the CFTC, financial
agency, is self-funded. But there is still the issue of
regulatory capture. But I think that has to be resolved
probably in other forums. I do not see anyone here--if someone
would like to put their hand up and say if the Fed should be
subject to the appropriation process, do I have any takers?
Barbara? Not even Consumer Federation of America.
[No response.]
Senator Reed. So I think this issue of----
[Laughter.]
Senator Reed. I think this issue of sort of, well, if they
do not have appropriate oversight by the appropriators, they
just will not be accountable to the American people defies the
financial system we have in place today.
Ms. Simpson, you talked about majority voting, and I just
want to clarify because the proposal that we had in the
legislation I think is essential. It fell out, unfortunately.
That would have required a director to receive the majority of
the votes cast. Today, a director could be elected to a board
with 10 percent of the votes or one vote if no one decides to
cast votes. That happens sometimes and leads to anomalies. So
effectively without this majority--without the ability to
nominate directors and then without the ability to insist they
at least get a majority vote, the leverage of shareholders is
diminished.
Now, we have made some improvements, but you would suggest
we should go further in terms of a majority vote. Is that
correct?
Ms. Simpson. Yes, thank you. And the situation you describe
is not that uncommon. We sort of had a look back last year.
Just in the Russell 3000, there are over 100 directors who did
not win a majority of the vote and who are still just quietly
sitting on the board. So far this year, another 36. So this is
an environment which is really very troubling. You know, this
may be a democracy, but it is of a very peculiar sort if you do
not have to win the election in order to keep yourself in
place. And, of course, the comment that was made about special
interests, I have to say with great respect to be rather like a
politician saying we should not trust the electorate with
something as important as the vote.
Senator Reed. But let me follow up on that line of
criticism that, well, this creates this lack of transparency
because you might have big voting blocs doing things.
Essentially whatever benefit you gain is equally shared by
every other shareholder. Is that----
Ms. Simpson. Yes, that is absolutely right, and two points
on that. First, CalPERS, being a great champion of
transparency, thinks that has to apply to us as well. We put
all of our votes on our Web site. Our policies are there for
you to see. And I think that is very important, and I would
encourage all investors to follow the same approach.
The other issue about the financial benefit is really
important. So even though CalPERS is so big, typically we will
hold about half a percent of a company, and if we want to do
anything, first of all, we have to collaborate with others;
and, second, you are quite right, the benefit is shared.
We had a report done for our board just before the end of
last year looking at 10 years of our investor engagement to see
what had happened at those companies, and sure enough, you went
from a situation where that group of companies went from
underperforming to producing excess returns. And, of course,
that is not just going to help CalPERS; it is going to help
every other shareholder. So there is a net-net gain in the
market.
Senator Reed. I think one of the dilemmas or sort of
contradictions is that the presumption, of course, is that
corporations are run for the benefit of shareholders, but I
think particularly when you look at the companies that failed--
Lehman Brothers, Bear Stearns--they were not being run for the
benefit of shareholders at all. They were being run for the
benefit of the management, with huge rewards to management. In
fact, as I sort of look back, it was a public ownership model
and a private compensation model, and it worked very well
until, you know, the tide turned.
In many respects, shareholders are the least powerful
people in corporations, and they are, according to corporate
law--and I will defer to Mr. Pitt and others. They are the
ultimate owners. They are the ones which every director has a
fiduciary duty to and manager has a fiduciary duty to. But it
appears from what has happened in the lead-up to this collapse
that shareholders were sort of the last people being
considered. Is that your view?
Ms. Simpson. Yes, I do agree with you. You know, we are the
one-armed paper hanger. We need to have the tools to hold
boards accountable, and I think what you will find, my
conclusion is that if shareholders have votes that do not
really matter and they do not have the ability to intervene in
an effective way, they think, OK, the system is designed.
Either you can sell or you can sue. Now, that is not going to
work for CalPERS because we are too big and we are too long
term. But we really do need the tools to be able to behave like
owners, and that is why--and I know it has been said, well, we
could go--Mr. Pitt has said we should go door to door with
companies in different States filing resolutions to have
amendments. But to be honest, we see this as a market
fundamental. If capitalism cannot turn to the owners to hold
companies accountable, then we should not be surprised when we
have the problems that we do.
Senator Reed. Thank you very much.
Chairman Johnson. Senator Menendez.
Senator Menendez. Well, thank you, Mr. Chairman. Thank you
for holding the hearing.
I look at this issue, and I think about what is the market.
The market is a series of investors seeking to invest in
companies that hopefully will provide them a yield, a return on
their investment so that they can personally prosper. And the
flip side of that is a series of companies looking for
investors so that they can grow their companies and prosper as
well. And so there are two essential ingredients here, and one
of them, but for their investments, would really not make the
market what it is. Without them there is no market. And so
investor protection seems to me to be incredibly important.
And I know that some say that the CalPERS of the world and
the unions of the world are special interests. They happen to
be the biggest singular investors along the way in this
marketplace. So I do not look at them as a special interest. I
look at them as a significant part of the marketplace,
representing a broad universe of individuals at the end of the
day who are taking their savings and making investments for
them. And so ultimately it seems to me that investor protection
in their respect as well is a very broad one because they
represent a very large universe of people, and at the end of
the day, more than ideological issues, I think they want to see
their investments grow on behalf of the people who they invest
in. So I have a little different view.
I have two sets of questions that I want to pursue. One is,
Ms. Roper, with you. Soon after Dodd-Frank was signed into law,
the SEC put out a study recommending a consistent best interest
of the customer or fiduciary duty standard for broker-dealers
and investor advisors, a priority that both Senator Akaka and I
successfully fought for in the Wall Street reform with our
honest broker amendment. And I know that the Certified
Financial Planner Board of Standards recently sent a petition
to the SEC with more than 5,000 signatures of financial
planning professionals who favor fiduciary duties for all
financial professionals giving investment advice.
Do you agree with having a high and consistent standard of
the best interests of the customer for all stockbrokers and
financial professionals? And if so, why?
Ms. Roper. Absolutely, I agree, and any of you who are the
recipients of my nearly daily letters on this subject during
the legislative battle maybe remember that. This is in many
ways the most important issue for retail investors. The last
investment decision most people will make is who to rely on for
recommendations. And the situation in the marketplace is this.
Mr. Atkins says, you know, broker-dealers and investment
advisors are doing two different things, so they should be
subject to two standards. But let us review that. They call
themselves by titles that are indistinguishable to the average
investor. They both offer extensive personalized investment
advice. And they both market their services primarily based on
that advice. If they are doing two separately distinctly
different things, why has the SEC allowed them to present
themselves in a way that makes it impossible for the average
investor to distinguish between them?
So if the investor cannot distinguish between them--and we
know from survey research and focus group research that they
cannot. In fact, the RAND study found that investors could not
tell whether their personal advisor was a broker or an
investment advisor, even after the differences had been
explained to them. So they cannot go into the marketplace and
make an informed decision based on an understanding of what
services are being offered or what the standard of conduct is
for those services.
So the reform that is needed is to ensure that when they
are doing the same thing, when they are providing personalized
investment advice to retail investors, they should be subject
to the same standards.
Now, the brilliance of the proposal that the SEC has put
out there is that it recognizes both the need to raise the
standard and the need to preserve investor access to a
transaction-based source of advice. Not every investor wants
ongoing account management. Not every investor wants, you know,
comprehensive financial planning. So investors benefit if there
is a source of advice available that is compensated through
commissions, that offers advice on a transaction basis. And the
SEC uses the authority that Dodd-Frank gave it to put out a
proposal that recognizes this. Brokers can still charge
commissions. Brokers can still sell proprietary products. They
can sell from a limited menu of products. And the SEC has said
they will deal with the principal trading issue. They are
making every effort to ensure that this advance in terms of the
standard of conduct nonetheless retains investor choice.
Senator Menendez. At the end of the day, they can make all
of their commissions, but they have one standard. That would be
the best interest of the investor.
Ms. Roper. Absolutely.
Senator Menendez. Otherwise, you could very well lead them
to investments that would not necessarily be in their best
interests, but for the standard----
Ms. Roper. Absolutely. Absolutely. There is--you know,
there is a difference between what you can do to satisfy a
suitability standard and what you would have to do to satisfy a
fiduciary duty. Now, they start from the same basis. You have
to know the customer. You have to do that analysis to determine
what is appropriate for that investor. The fiduciary duty
requires the broker to take an additional step and have a
reasonable basis for believing that what they are recommending
is not just appropriate for the investor, but in the best
interest of the investor within the limited menu of options
that they have available to sell.
And where they have conflicts of interest, they are still
able to operate, but they have to fully disclose those
conflicts of interest to the investors. So they can no longer
make recommendations based on their own financial interest
because they get higher commission without disclosing that
conflict to the investor and without then ensuring that that
recommendation is also in the best interest of the investor,
and not just their own bottom line.
Senator Menendez. Thank you very much.
I have one other question. I want to turn to Mr. Turner.
Mr. Turner, one of the provisions that I successfully included
in Dodd-Frank would require publicly listed companies to
disclose in their SEC filings the amount of CEO pay, the
typical worker's pay at that company, and the ratio of the two.
Now, over the last few decades, CEO pay has skyrocketed while
the median family income has actually gone down.
There are those in the House that have opposed this because
they say it is too burdensome for companies to disclose that,
and second, that the information is not useful to investors. I
find it hard to believe that companies that do all kinds of
complicated calculations for everything else involving their
revenues and expenses would find it difficult to take their
2,000 employees, figure out how much employee number 1,000 is
paid, and report that one number to the SEC. It seems to me
that it is much more about hiding the fact that, many times,
CEOs have 400 times the pay of their typical employee.
Do you think it would be burdensome for companies to figure
out how much their median worker is paid and report that
number?
Mr. Turner. Senator, as you know, I was an executive in a
semiconductor company that was international. We were one of
the larger importer-exporters at the time, in fact, in the
country, and I do not think--in fact, I would be surprised if
for most companies that was a difficult thing. First of all, it
is something you ought to be managing, so you only manage what
you measure in the first place. And if the compensation
committee of a board, and I have sat on some of these boards,
was not even looking at that ratio, I would probably be
concerned. It would tell me there is a lack of management here,
a degree of management that should exist.
But in terms of just getting the raw data, no, I think
there are ways you can go about it. The SEC can implement some
rules. I think they have been encouraged to implement some
rules that are reasonable that would not have a great deal of
cost. And again, let us keep in mind, when we talk about cost,
this cost global markets $28 trillion. It cost U.S. investors
$10 to $11 trillion. Much of that was due to very, very poor
incentive packages. And in light of the fact that executive
compensation this year--last year was up 23 percent while Main
Street wages went up zero--zero--I think it is fair to turn
around and start managing and taking a look at that issue, and
I think compensation committees should. I think they can. I
think CFOs in the same role I was in can get that number. And,
no, I do not expect that to be a high-cost number. If it is a
high-cost number, that company probably has some other
management problems, as well.
Senator Menendez. Thank you. Thank you, Mr. Chairman.
Chairman Johnson. Senator Akaka.
Senator Akaka. Thank you very much, Mr. Chairman, and I
welcome our witnesses here as we hear what is the latest that
has been happening to the Dodd-Frank bill and how it has
impacted our national community.
Ms. Roper, you have mentioned that the Dodd-Frank bill is a
multi-protection framework and it provides tools that investors
need to deal with, and I want to speak toward the Investor
Advocate. In the Office of the Investor Advocate, which was
created to empower retail investors and represent their
interests with the SEC and SROs, there will now be an
independent external check that investors did not have during
the Madoff or Stanford Ponzi schemes or the financial crisis.
My question to you is, how will the structure of the Investor
Advocate affect its ability to achieve its purpose?
Ms. Roper. I think we know from looking at how Inspector
Generals function within agencies that if we want them to have
any sort of ability to hold the agency accountable, they have
to be independent and they have to have the ability to report
out when they find problems. And the strength, I think, of the
investor protection, the Office of Investor Advocate provision
in this Act are precisely those, frankly, that former Chairman
Pitt has criticized. They are the provisions that ensure that
this office does not become just another weak and meaningless
addition to the SEC bureaucracy.
You know, agencies do not like their IGs. They are
uncomfortable with that function within the agencies. But I
think we can all agree that they do perform a valuable function
in terms of holding the agency accountable. The Office of
Investor Advocate has exactly that same potential, to hold the
agency accountable for being responsive to investor concerns.
Now, I find it interesting that people who say that the
SEC's job to be the investor advocate are so threatened by the
notion that it would be held accountable for listening to
investor concerns. The Office of Investor Advocate cannot
compel them to do anything. But they cannot be ignored, because
they have to--the Commission has to respond. They cannot be
denied access to the paperwork that they need to analyze
proposals. They have to be built into the process of developing
the Commission's rule proposals and agenda.
You know, I think that it is instructive that these same
provisions that are designed to make the agency accountable to
investors are viewed as so threatening by some. When I hear
these words, the SEC, we do not need this because the SEC is
the investor advocate, well, I have been an investor advocate
for 25 years and, you know, I do not think you would find a
single investor advocate who would agree with that statement.
It is not the SEC's job to advocate on behalf of investors, and
in the best of times, investors find it very difficult to have
their voices heard.
So I think this is an important addition to the Act. I look
forward to having the office established and up and running,
and I think we can trust--the Chairman said, we will appoint
this person. We will not put cowboys into that office who will
behave recklessly. It is not in their interest.
And just one final note. This question of the--the threat
is that the Investor Advocate can criticize the agency action.
What we are talking about here is that they report to their
oversight committee. Now, Members of this Committee just
expressed a lot of concern about the ability of Congress to
provide effective Congressional oversight. The fact that the
Office of Investor Advocate will be reporting to the oversight
committee should ensure that the committees can do a better job
of providing oversight to ensure that the Commission is
effectively protecting the interests of investors.
Senator Akaka. Thank you.
Mr. Massey, you have mentioned that this bill should be
implemented fully, and Mr. Turner also said that the law should
be enforced. Mr. Massey, NASAA's statement on an SEC study on
the obligations of broker-dealers and investment advisors said
that a uniform fiduciary standard would have a, and I quote,
``significant positive impact on investors.'' Do you have
anything to add to Ms. Roper's comments about how investors
would be positively impacted by a uniform fiduciary standard?
Mr. Massey. Senator, I agree substantially with what Ms.
Roper said. I would add that I believe that it is appropriate
to introduce a fiduciary standard on those brokers who are
presenting themselves as purveyors of investment advice.
The brokerage industry has gone to a marketing mode in
which it holds itself out to retail investors as being trusted
advisors. Surveys have shown that regular retail investors do
not know the difference between a stockbroker and an investment
advisor, and they also believe that when they are sitting in
front of a financial professional, that that financial
professional is acting in their best interest, but that is not
the situation.
The fiduciary duty that has been discussed would be imposed
only on the brokers who are providing investment advice just
like investment advisors provide investment advice. So if you
are going to present yourself as a trusted advisor, you ought
to be held to the standards of a trusted advisor and be
responsible. The benefits to the investors would be a mandatory
disclosure of any conflicts of interest that might show any
kind of bias in that advice that is being communicated. The
benefits would be to obtain full information about the--
enabling the investor to choose the best performing product at
the lowest expense to the investor. It makes sense to me and we
fully support it.
Senator Akaka. Thank you very much. Thank you, Mr.
Chairman.
Chairman Johnson. Senator Hagan.
Senator Hagan. Thank you, Mr. Chairman, and thank you for
holding this hearing on investor protection after the financial
crisis.
I did want to welcome David Massey, who is from my State in
North Carolina, and he has been a strong advocate for
investors, especially those who lack the expertise or resources
to protect themselves, so thank you for being here, too, and
all of thee other panel members for being here.
I did want to ask Mr. Pitt, Mr. Atkins, and Mr. Turner a
question concerning the Department of Labor. Right now--
recently, the DOL has unilaterally proposed regulations under
ERISA that would redefine the term ``fiduciary,'' and many of
my colleagues, I know, have expressed concerns about the
coordination that is taking place, or the lack of coordination,
too, between the SEC and the Department of Labor. In light of
the SEC's recommendation that the Commission use its authority
under Dodd-Frank to promulgate a uniform standard, and given
you all's expertise at the SEC, I wanted to get your thoughts
on this matter. Are you concerned that DOL's changes have not
been made in coordination with the SEC, and what could some of
the consequences of this coordination, if it does not take
place, if we do not have the coordination?
Mr. Pitt. I believe in requiring coordination between
agencies of Government. It is one Government, and when Paul
Atkins and I were there, when we would take enforcement actions
that affected national banks or affected entities overseas, we
would coordinate with the Federal Reserve Board or the State
Department. I think there is no place for unilateral action
when other agencies have a vested interest. And indeed, in the
context of pension investments, the SEC has a lot of expertise
to offer in that area.
Senator Hagan. Mr. Atkins?
Mr. Atkins. Yes, Senator. I agree with Chairman Pitt. Both
SEC and the Department of Labor have overlapping jurisdiction
with respect to these pension funds, 401(k) offerings, which
touch just about everybody in the country. So, it is really
vital that they coordinate, and as you are saying, the current
situation has been characterized apparently by a lack of
coordination. What is really important here are the
consequences of unilateral action. It will raise costs and
restrict choices that people have with respect to their 401(k)
programs. The huge liability that will come down to peripheral
actors will really discourage those people from being involved.
Senator Hagan. I have heard that quite a bit.
Mr. Turner?
Mr. Turner. Senator Hagan, the proposals that you refer to
relate to a fiduciary standard that, as I recall, was adopted
back at the time of ERISA, back in 1974. So things have
dramatically changed since then. I think the Secretary over
there is absolutely correct that they need to be updated. It
has been, what, 35, 36, 37 years since those things were done,
and investment funds like 401(k)s, IRAs, et cetera, have
dramatically changed since then. I have served on the board of
a mutual fund as a trustee. I currently am an independent
member of the board of a $40 billion pension fund, as well, so
have to deal with those fiduciary laws. And I do think that
they need to be changed and updated.
The things she is changing to, in fact, are already in many
instances incorporated into our contracts, so she is catching
up the law to already what exists in many of our business
contracts. So I do not think it is as dramatic a change as what
some criticize her for. So I think they are good rules. I think
she should move forward with them. But to the same point that
Paul and Harvey say, though, in this city, it is always good to
have people coordinate with one another and be talking with one
another. I do not care whether it is the banking regulators,
the SEC, CFTC. The more you can get in the room and hash over
things, I think that is good.
But ultimately, the independence of any agency or any
cabinet position, I think, is important. Ultimately, it is the
Department of Labor Secretary that is responsible for those
rules. So if she goes through consultation, including with the
SEC, and then decides after that to go ahead and move, I do not
have a problem with that because I think she is moving wisely
in the right direction. But I would certainly encourage her to
do that after consultation with the Commission.
Senator Hagan. Well, it seems to me that it would be a
problem if we have two different definitions of ``fiduciary,''
one at the DOL and then one at the SEC.
Mr. Turner. I would say this, that the things she is
dealing with--there are two different things here. The
fiduciary standard she is dealing with is dealing with what
ultimately runs to the trustees on those funds. It will be
applied broader, and I think to that extent, your concern has
got some basis. But I do not think it is necessarily going to
be the same fiduciary situation that the SEC necessarily has,
so I do not know that, ultimately, at the end of the day, if
they all talk to one another, I think you can have them talk to
one another until they get blue in the face, and they may
actually find that they do not have the same fiduciary standard
at the end of the day.
Ms. Roper. Yes. I think there is an issue here. I actually
think if you look at it, you will find that the changes to the
fiduciary definition under DOL actually bring it closer into
alignment with the definition of fiduciary under securities
laws. The problem is not so much with the definition, but then
what flows from that definition under ERISA.
And when I first started looking at this issue, I assumed,
oh, it is fiduciary duty. I am all for it. As we have looked at
the issues more closely, there are issues with the ERISA
proposal, I mean, with the DOL proposal on fiduciary duty and
they are varied. One of them is that there is a conflict with
the business conduct rules for swaps dealers. And I was
involved working with the drafters in writing that section of
the legislation and the clear intent was to avoid bringing the
ERISA fiduciary duty into this interaction between swaps
dealers and special entities because it then brings--you know,
you cannot have an adverse interest. You basically cannot be a
counterparty.
Now, members worked very hard to draft the legislation in a
way that did not bring ERISA into play. Under the DOL fiduciary
definition, there are things that swaps dealers that would have
to do to satisfy the business conduct rules that would make
them fiduciaries under the DOL definition and then would
preclude them from acting as counterparties, precisely what
Congress was trying to avoid.
There are other problems. I think a legitimate concern
about what happens in, say, the individual retirement account
context----
Senator Hagan. I am hearing a lot of concerns on that.
Ms. Roper. Right. If you bring into play the DOL, the ERISA
restrictions on any third-party compensation, say, 12(b)(1)
fees, they are not--these are not irresolvable problems. I
mean, you can--but the real issue here is so DOL rolled out
what I think is a very well intended definition and one that
does, in fact, come closer to the SEC definition, but it rolled
them out without putting out the prohibited transaction
exemption explanations at the same time. So people do not know
how it is going to work in the real world. And all of ERISA
seems I am not an ERISA expert, but all of it seems to be
devoted to figuring out what the prohibited transaction
exemptions are.
And so you cannot sort of reasonably comment on the DOL
proposal of the fiduciary definition unless you know how it is
going to interact with those exemptions. So while we would very
much like to see the agency move forward with a proposal that
is designed to benefit investors, there are issues with that
definition that need to be resolved before it is finalized.
Senator Hagan. I see that my time has expired, but I do
have other questions that I will submit to the record. Thank
you, Mr. Chairman.
Chairman Johnson. Thank you.
Senator Shelby has one last question.
Senator Shelby. Just a few observations. Thank you, Mr.
Chairman, for calling this hearing. I think it is important.
One of my observations, and I have asked everybody that has
come before this Committee for the last 25 years that were
nominated for the Securities and Exchange Commission, a
Commissioner and the Chairman, who owns a corporation? Who
does? And what does a corporation exist for, for whom? The
shareholder. Who owns it? The shareholder. Not management. Not
special interests and so forth. In other words, shareholders,
the investors, certainly not the directors or management.
I believe that we need to have--create conditions, that is,
our regulators and so forth, where a corporation cannot be
hijacked for financial reasons by management or by special
interests also hoping to advance a political agenda, because
why do you buy stock? To make money, for it to grow and so
forth.
So our challenge, I believe, is how do we balance all of
this without destroying something. We certainly do not want to
give management a free pass. On the other hand, I do not think
we ought to give special interests a free pass to hijack a
company to advance something other than making money for me or
my pension fund or my mutual fund or whatever. That is my
observation. That is a challenge for us, as I know, and I do
appreciate all of you coming here today. I think we had a
lively discussion and a very important one.
Thank you, Mr. Chairman.
Chairman Johnson. I thank each witness for testifying and
we appreciate your concern for the protection of investors in
the United States securities markets.
I ask all the Members of the Committee to submit any
questions for the record by close of business next Tuesday, and
I ask the witnesses to submit your answers to us in a timely
manner.
This hearing is adjourned.
[Whereupon, at 11:58 a.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF DAVID MASSEY
NASAA President and North Carolina Deputy Securities Administrator
July 12, 2011
Chairman Johnson, Ranking Member Shelby, and Members of the
Committee, I'm David Massey, Deputy Securities Administrator for North
Carolina and President of the North American Securities Administrators
Association, Inc. (``NASAA''). I am honored to be here today to discuss
how the Dodd-Frank Wall Street Reform and Consumer Protection Act (the
``Dodd-Frank Act'') is providing enhanced protection to investors,
particularly Main Street Americans who are looking to lawmakers and
State and Federal regulators to help them rebuild and safeguard their
financial security.
The Wall Street reforms and investor protection provisions in the
Dodd-Frank Act were born out of necessity. The financial crisis made it
clear that the existing securities regulatory landscape required an
overhaul. NASAA sincerely appreciates the work of Chairman Johnson and
Members of this Committee to ensure that investor protection remained
the foremost goal of the legislative effort to usher in the next
generation of financial services regulation.
This comprehensive law was crafted to promote stronger investor
protection and more effective oversight to help prevent another
economic crisis and restore the confidence of Main Street investors.
The Dodd-Frank Act addresses a number of critical issues for investors
by incorporating disqualification provisions to prevent securities law
violators from conducting securities offerings under SEC Regulation D,
Rule 506; strengthening the accredited investor standard; and
increasing State regulatory oversight of investment advisers. Dodd-
Frank also includes a provision to safeguard senior investors from
unqualified advisers and creates an investor advisory committee to
advise the SEC on its regulatory priorities. In two other priority
areas for investors, fiduciary duty and arbitration, the law authorizes
the SEC to take action to provide enhanced protections and remedies for
investors.
Role of State Securities Regulators
State securities regulators have protected Main Street investors
from fraud for the past 100 years, longer than any other securities
regulator. From the enactment of the first blue sky securities law in
Kansas in 1911, State securities regulators continue, more so than any
other kind of regulator, to focus on protecting retail investors. Our
primary goal has been and remains to advocate and act for the
protection of investors, especially those who lack the expertise,
experience, and resources to protect their own interests.
The securities administrators in your States are responsible for
enforcing State securities laws, the licensing of firms and investment
professionals, registering certain securities offerings, examining
broker-dealers and investment advisers, pursuing cases of suspected
investment fraud, and providing investor education programs and
materials to your constituents. Like me, 10 of my colleagues are
appointed by State Secretaries of State, five come under the
jurisdiction of their States' Attorneys General, some are appointed by
their Governors and Cabinet officials, and others work for independent
commissions or boards. Many call us ``local cops on the securities
beat.'' I think of my State colleagues at NASAA as a national network
of local crime fighters working to protect investors.
Securities regulation is a complementary regime of both State and
Federal securities laws, and we work closely with our Federal
counterparts to uncover and prosecute violators of those laws.
States have been the undisputed leaders in criminal prosecutions of
securities violators because we believe in serious jail time for
securities-related crimes. Over the past few years, ranging from 2004
through 2009, State securities regulators have conducted nearly 14,000
enforcement actions, which led to $8.4 billion ordered returned to
investors. And, we have worked to secure convictions for securities
laws violators resulting in more than 6,000 years in prison.
Traditionally, State securities regulators have pursued the
perpetrators at the local level who are trying to defraud the ``mom and
pop'' investors in your States. That allows the SEC to focus on the
larger, more complex fraudulent activities involving the securities
market at a national level.
Even so, States have successfully exposed and addressed the
conflicts of interest among Wall Street stock analysts by requiring
changed behavior. We led all regulators on late trading and market
timing in mutual funds. And State securities regulators continue to
lead the nationwide effort to address problems related to the offer and
sale of auction rate securities, an effort that has resulted in the
largest return of funds to investors in history. As regulators, we are
convinced that every investor deserves protection and an even break.
Enhanced Investor Protections in Dodd-Frank
As we enter our second century of investor protection, State
securities regulators are at the forefront of investor protection. By
passing and signing the Dodd-Frank legislation into law, President
Obama and Congress signaled the beginning of a new era of investor
protection and financial market oversight. Reforms now taking shape at
the national level are giving new authority to State securities
regulators to address the challenges facing 21st century investors.
Trust in the markets must be restored if our system of capital
formation is to thrive. The Dodd-Frank Act helps restore investor trust
by enacting a number of much-needed investor protections that empower
State securities regulators to protect citizens from fraud and abuse in
the financial markets.
Reducing Investor Risk in Rule 506 Offerings
Section 926 of the Dodd-Frank Act took a necessary first step
toward reducing risks for investors in private offerings by requiring
the SEC to issue rulemaking excluding securities law violators from
utilizing the Regulation D, Rule 506 exemption (``Rule 506'') from
securities regulation. In 1996, the National Securities Markets
Improvement Act dramatically curtailed the authority of State
securities regulators to oversee these unregistered private offerings.
Rule 506 offerings are also exempted from Federal oversight and the SEC
generally does not review them, so they receive virtually no regulatory
pre-screening.
These unregistered private offerings naturally have become a
favorite vehicle for unscrupulous promoters, who use the Rule 506
exemption to fly under the radar. In 2009, more than 26,000 of these
offerings were filed with the SEC with an estimated offering total of
$609 billion. Section 926 took the important step of ensuring that
promoters and brokers who have a criminal or disciplinary history will
no longer be able to prey on investors by using this exemption from
registration.
We appreciate the inclusion in the Dodd-Frank Act of the so-called
``bad actor'' disqualifier language to prevent recidivist securities
law violators from conducting securities offerings under Rule 506.
However, we continue to believe the best way to deter fraud is to fully
reinstate State authority over these unregistered offerings through the
repeal of Subsection 18(b)(4)(D) of the Securities Act of 1933.
Allowing State securities regulators to review these offerings provides
regulators with a powerful weapon to detect and prevent fraud.
As required under Section 926, the SEC recently proposed rules
mandated by the Dodd-Frank Act to disqualify known securities law
violators from using the exemption contained in Regulation D, Rule 506.
The proposed rules protect investors without hampering legitimate
capital-raising by disqualifying felons and other ``bad actors'' from
evading registration and review. Under the proposal, an offering would
not qualify for the exemption from registration if the company issuing
the securities or any other person covered by the rule had a specified
``disqualifying event.''
NASAA is a long-time supporter of the adoption of disqualification
provisions for securities offerings under Rule 506. We commend the SEC
for proposing disqualification provisions that are in line with many of
our concerns and will continue to work with the SEC to strengthen the
proposal.
Strengthening the ``Accredited Investor'' Standard
Private offerings were originally intended only for institutional
investors and sophisticated individuals who were presumed capable of
assessing risks and making investment decisions without the benefit of
regulatory review and registration. The ``accredited investor''
standard, which sets out certain financial thresholds that must be met
before an investor can purchase private offerings, was adopted as a
means of assessing which investors could presumably fend for
themselves. The standard as adopted by the SEC in 1982 has remained
unchanged. Inflation has severely diminished the standard and eroded
the investor protection goals it was meant to serve. To make matters
worse, investors, and particularly retirees, with much of their net
worth tied to their homes have been able to meet these diminished
standards and purchase risky private placements that they may not fully
understand.
NASAA has long advocated for adjusting the definition of
``accredited investor'' in light of inflation and has expressed concern
at the length of time the thresholds contained in the definition have
remained static.
Section 412 of the Dodd-Frank Act addressed this problem by
adjusting the financial thresholds in the definition of an ``accredited
investor'', and by removing the value of the investor's primary
residence from the net worth calculation. Dodd-Frank also directs the
SEC, 4 years after enactment, and once every 4 years thereafter, to
review the definition of ``accredited investor'' to determine whether
the requirements of the definition should be adjusted or modified for
the protection of investors, in the public interest, and in light of
the economy. Upon completion of the review, the SEC may adjust the
other economic elements of ``accredited investor''.
Raising the standard for individual investors will provide greater
protection for investors and will aid State regulators in enforcement
activities by furthering more accurate suitability determinations for
those individuals who choose to take greater risks by investing in
unregistered securities.
Expanding State Oversight of Investment Advisers with the IA ``Switch''
The oversight of investment advisers has always been a partnership
between State and Federal regulators, both of which are directly
accountable to the investing public. Congress recognized the strong
record of the States in this area when it enacted Section 410 of Dodd-
Frank to expand State authority to include mid-sized investment
advisers with $25 million to $100 million in assets under management.
By the time this provision takes effect in mid-2012, State
securities regulators will oversee the majority of all registered
investment adviser firms. Having the States assume responsibility for
mid-sized advisers will allow the SEC to focus on larger advisers.
Investors will benefit from this change because it will enable the SEC
to focus on the largest investment advisers, while mid-sized and
smaller advisers will be subject to the strong State system of
oversight and regulation.
States continue to prepare to receive oversight of approximately
3,200 mid-sized investment advisers from the SEC. Over the past year,
NASAA members have been hosting a series of workshops for investment
advisers in their jurisdictions. This outreach program is helping to
educate federally regulated advisers about State registration and
examination requirements. In addition, NASAA developed a memorandum of
understanding calling for State securities agencies, when necessary, to
assist one another with examinations of investment advisers. This MOU
embodies the long-standing practice among NASAA members to work
together to protect investors. NASAA members are actively engaged in
sharing resources, including staff expertise, in an effort to bolster
examination programs.
Last month, the SEC extended its timeline for this ``investment
adviser switch'' from later this year into the middle of 2012 to
accommodate the reprogramming of the Investment Adviser Registration
Depository (IARD) system and to give investment advisers sufficient
time to transition from SEC to State registration. NASAA remains
committed to coordinating the actions of the States in response to the
SEC's timetable and we will continue to work with the SEC, as well as
industry, to see that the switch by investment advisers from SEC
regulation to State regulation goes as efficiently and seamlessly as
possible.
Extending the Fiduciary Duty
State securities regulators routinely see the financial devastation
caused when the interests of investors do not come first. That is why
NASAA has consistently urged policymakers to protect investors by
requiring all who provide investment advice about securities to be held
to the fiduciary duty currently applicable to investment advisers under
the Investment Advisers Act of 1940.
Section 913 of the Dodd-Frank Act called for the SEC to examine the
obligations of brokers, dealers, and investment advisers. We support
the recommendations of the SEC staff report to apply a fiduciary duty
to broker-dealers who provide personalized investment advice about
securities to retail customers and believe it will have a significant
positive impact on investors. NASAA looks forward to assisting the
Commission as it develops rules to apply a fiduciary standard of care
and loyalty to all who provide investment advice to ensure that this
standard is as strong as the existing fiduciary duty of the Advisers
Act.
Delays to Important Investor Protections
As with the fiduciary duty provision, Dodd-Frank shifts the
ultimate responsibility to decide whether, and in what form, several
important investor safeguards will be delivered. For example, the SEC
and the Commodity Futures Trading Commission were given broad and
sorely needed regulatory authority over certain segments of our
marketplace, such as over-the-counter derivatives and private funds.
Yet in spite of their increased responsibility, the agencies are
operating at inadequate funding levels. NASAA has consistently urged
Congress to support funding the SEC at the level requested by the
Administration so that the agency can fully implement its
responsibilities mandated by Dodd-Frank. We support funding the SEC at
the $1.3 billion level authorized by Dodd-Frank to carry out the
functions, powers and duties of the Commission for FY 2011.
Giving Investors a Voice at the SEC
The SEC has already deferred action on a number of new activities,
such as the creation of the Office of Investor Advocate and the
Investor Advisory Committee. In 2009, the SEC established an Investor
Advisory Committee to provide the Commission with a variety of
viewpoints regarding its regulatory agenda. The committee included a
State securities regulator, along with other investor advocates, to
make certain that all SEC regulatory actions serve the best interests
of investors.
This committee wound down in anticipation that legislation,
ultimately the Dodd-Frank Act, would resurrect it under a statutory
mandate. Indeed, Section 911 of the Dodd-Frank Act did require the SEC
to establish and maintain a committee of investors to advise the SEC on
its regulatory priorities and practices and also designated that a
State securities regulator continue to serve as a member. SEC
Commissioner Luis Aguilar recently said that this committee is of
``critical importance to ensuring that the SEC is focused on the needs
and the practical realities facing investors.'' Unfortunately, budget
uncertainty has forced the SEC to defer the creation of the Investor
Advisory Committee.
Providing Choice of Forum for Investors and Promoting Transparency
Every year thousands of investors file complaints against their
stockbrokers. Almost every broker-dealer presently includes in their
customer agreements a mandatory pre-dispute arbitration provision that
forces those investors to submit all disputes that they may have with
the brokerage firm or its associated persons to mandatory arbitration.
If cases are not settled, the only alternative is arbitration. For all
practical purposes, the only arbitration forum available to investors
is one administered by the Financial Industry Regulatory Authority
(FINRA).
Arbitration has been presented to the investing public as an
inexpensive, informal, totally private process that results in a speedy
resolution of cases. However, the mandatory arbitration provisions in
contracts take away the ability of a harmed customer to ``have their
day in court'' by forcing investors into a forum that limits discovery,
reduces the pleading standards and allows decisions in which there is
severely limited appeal. Arbitration as it exists does not treat the
investing public fairly. If the system were a level playing field,
arbitration probably would not be a universal requirement of the
brokerage industry, and the investing public likely would embrace it
voluntarily. Not surprisingly, studies have confirmed the belief that
the securities arbitration forum is not perceived as fair to investors,
and recovery rates in fact favor the securities industry.
In February, the SEC approved a FINRA rule proposal that would
allow all investors filing arbitration claims the option of having an
all-public panel, thus expanding a pilot program to all investor
claims. Historically, the panels had been comprised of two public
arbitrators and an arbitrator who had worked in the securities
industry. The FINRA rule change was an important step toward leveling
the playing field for investors and improving the integrity of the
arbitration system. However, with the economy as it is today, investor
confidence remains very low. Another major step in restoring investor
confidence and industry integrity would be to restore investor choice
in their agreements with their brokerage firm.
Section 921 of Dodd-Frank provides the SEC with rulemaking
authority to prohibit, or impose conditions or limitations on the use
of mandatory predispute arbitration agreements if it finds that such
prohibition, imposition of conditions, or limitations are in the public
interest and for the protection of investors. Pursuant to this
provision, Congress should urge the SEC to use the authority provided
the agency in Section 921 and impose rules prohibiting the mandatory
nature of pre-dispute securities arbitration. This would allow
investors the choice they ought to have between arbitration and
litigation in an independent judicial forum.
Funding the Grant Program to Safeguard Senior Investors from
Unqualified Advisers
One of the highest priorities of NASAA's membership is to protect
vulnerable senior investors from investment fraud. We have long been
concerned with the use of misleading professional designations that
convey an expertise in advising seniors on financial matters. Many of
these designations in reality reflect no such expertise. Our concern
led us to promulgate a model rule designed to curb abuses in this area,
and 27 States have adopted rules or laws governing the use of these
designations.
Section 989A of Dodd-Frank recognizes the harm to seniors posed by
the use of such misleading activity and establishes a mechanism for
providing grants to States as an incentive to adopting provisions
meeting the minimum requirements of NASAA's model rule on the use of
designations in the offer or sale of securities or investment advice.
The law provides parallel incentives for States that have adopted
provisions meeting the minimum requirements of the National Association
of Insurance Commissioners' model rule on the use of senior
designations in the sale of life insurance and annuities.
The grants are designed to give States the flexibility to use funds
for a wide variety of senior investor protection efforts, such as
hiring additional staff to investigate and prosecute cases; funding new
technology, equipment, and training for regulators, prosecutors, and
law enforcement; and providing educational materials to increase
awareness and understanding of designations.
Unfortunately, disputes over the funding and leadership of the
Consumer Financial Protection Bureau (``CFPB'') not related to investor
protection have indefinitely delayed the creation of the senior
investor protection grant program under Section 989A. The CFPB Office
of Financial Literacy must be fully funded and operational to begin
issuing grants of up to $500,000 to States that have adopted the NASAA
and NAIC model rules on misleading senior designations. These important
senior investor protections should not be delayed because Congress has
not provided sufficient funding for the Federal financial regulatory
agencies.
Conclusion
As discussed above, the Dodd-Frank Act provides meaningful,
tangible benefits to investors. It requires the SEC to raise standards
that are long overdue and blocks fraudulent actors from taking
advantage of exemptions that should be reserved for reputable issuers.
The Dodd-Frank Act empowers the SEC to raise the standards under which
broker-dealers provide investment advice to ensure that the interests
of investors come first. The law also recognizes the investor
protection contributions of State regulators by increasing our
authority over the regulation of investment advisers and by ensuring we
have a voice on both the SEC's investor advisory committee and the
Financial Stability Oversight Council. I am honored to serve on the
FSOC along with my State banking and insurance colleagues. State
regulators bring to the FSOC the insights of ``first responders'' who
see trends developing at the State level that have the potential to
impact the larger financial system.
I want to thank Chairman Johnson for his consistent support for the
important investor protections included in the Dodd-Frank Act. I
appreciate your comments, Senator Johnson, that it ``would be dangerous
and irresponsible,'' to rollback these hard-won reforms.
Our message to Congress is simple and clear: Please continue your
commitment to protecting investors and do not undermine the Dodd-Frank
Act's regulatory authority either directly through legislative repeals
or indirectly through a lack of appropriate funding or delayed
execution.
We look forward to working cooperatively with the Senate Banking
Committee, as well as all Members of Congress and fellow regulators to
ensure full implementation of the investor protections included in the
Dodd-Frank Act.
______
PREPARED STATEMENT OF LYNNETTE KELLY HOTCHKISS
Executive Director, Municipal Securities Rulemaking Board
July 12, 2011
Good morning Chairman Johnson, Ranking Member Shelby and Members of
the Committee. I appreciate the invitation to testify today on behalf
of the Municipal Securities Rulemaking Board.
Since the MSRB was created by Congress in 1975 as the principal
regulator for the municipal securities market, the MSRB has placed
investors front-and-center in all of our market initiatives. Through
our rulemaking over municipal market intermediaries as well as our
ground-breaking market information systems, we have put in place
protections for the significant U.S. retail market for municipal
securities.\1\
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\1\ The size of the municipal market is approximately $3.7
trillion. See Bloomberg L.P., Municipal Market: Bloomberg Brief (June
21, 2011). It is estimated that approximately two-thirds of the
municipal market is comprised, directly or indirectly, of retail
investors. See SIFMA Statistics, U.S. Municipal Securities Holders,
Quarterly Data to Q1 2011.
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While the MSRB's original jurisdictional authority was limited to
the regulation of broker-dealers and banks that buy, sell, trade and
underwrite municipal bonds (referred to herein as ``dealers'') with the
principal purpose of protecting investors, Title IX of the Dodd-Frank
Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) greatly
expanded our ability to protect investors and increased our
responsibilities to the marketplace by vesting us with the duties of
regulating municipal advisors and protecting State and local government
issuers, public pension plans and obligated persons. Over the past
year, the MSRB has undertaken substantial rulemaking and transparency
efforts to promote high standards of professional conduct and market
disclosure aimed at creating conditions for fair, well-informed
financial decisions by all market participants.
The MSRB cannot act as a guarantor against poor decisions by either
investors or issuers, or guard against the occurrence of adverse events
in the market. However, we believe that a principles-based approach to
regulating market intermediaries leads to the best possible outcome in
terms of market fairness and efficiency. Key elements to ensuring such
a fair and efficient market are such principles as suitability,
disclosure, pricing and liquidity for investors. These elements also
can have a substantial impact on the taxpayer's wallet and the public's
confidence in the municipal market.
Since Dodd-Frank was signed into law, the MSRB has been operating
under the leadership of its first majority-public Board of Directors,
which represents the interests of the public and municipal market
investors and issuers, in addition to regulated entities. This public
Board has moved decisively but carefully to put in place safeguards
that more fully protect the municipal market that is so fundamental to
the public interest.
Since last October, MSRB rulemaking initiatives have addressed
fiduciary duty, fair dealing, municipal advisor registration, pay-to-
play, gift-giving and supervision. We are also developing municipal
advisor professional qualifications requirements, including appropriate
licensing examinations, and have enhanced our Electronic Municipal
Market Access (EMMA) Web site to allow investors unprecedented access
to market data and disclosures. These are the initiatives I would like
to discuss with you today.
The Dodd-Frank Act and the Municipal Market
First, I would like to address the impact of the Dodd-Frank Act on
the municipal market. This piece of legislation represents the most
significant change affecting the municipal market since 1986--including
key changes in the regulatory landscape for municipal advisors,\2\
asset-backed securities,\3\ credit rating agencies \4\ and
derivatives.\5\ Furthermore, to our knowledge, this is the first time
Congress has enacted a law to protect issuers of securities.\6\
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\2\ Pub. L. No. 111-203 975, 124 Stat. 1917 (2010).
\3\ Pub. L. No. 111-203 942-943, 124 Stat. 1897 (2010).
\4\ Pub. L. No. 111-203 932, 124 Stat. 1872-1888 (2010).
\5\ Pub. L. No. 111-203 764, 124 Stat. 1785 (2010).
\6\ Pub. L. No. 111-203 975, 124 Stat. 1918 (2010).
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The MSRB's expanded authority falls under Title IX of the Dodd-
Frank Act, which covers investor protections and improvements to the
regulation of securities intermediaries. The Dodd-Frank Act granted the
MSRB regulatory jurisdiction over municipal advisors.\7\ It also
provides that MSRB rules for municipal advisors are to, among other
things: (1) promote fair dealing, the prevention of fraudulent and
manipulative acts and practices, and the protection of investors,
municipal entities, and obligated persons; (2) prescribe means
reasonably designed to prevent acts, practices, and courses of business
that are not consistent with a municipal advisor's fiduciary duty to
its municipal entity clients; (3) prescribe professional standards; (4)
provide continuing education requirements; (5) provide for periodic
examinations; (6) provide for recordkeeping and record retention; and
(7) provide for reasonable fees and charges necessary or appropriate to
defray the costs and expenses of operating and administering the
Board.\8\
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\7\ Pub. L. No. 111-203 975, 124 Stat. 1917 (2010).
\8\ Pub. L. No. 111-203 975, 124 Stat. 1919 (2010).
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The establishment of a comprehensive set of rules for the
activities of municipal advisors will provide significant protections
to State and local governments and other municipal entities and will
greatly enhance the existing protections afforded to investors beyond
the protections already provided by the MSRB's longstanding investor
protection rules covering broker-dealers and banks. By way of
illustration, the MSRB has previously established a series of investor
protection rules covering the activities of brokers marketing 529
college savings plans, which are investments sold exclusively to
parents, grandparents and other retail investors, many of whom may have
little or no prior experience as investors. With the enactment of Dodd-
Frank, the MSRB now has authority to adopt a more comprehensive set of
rules that go beyond the brokers marketing 529 plans to professionals
that advise the States on the structure and related fundamental matters
relating to the operation of such 529 plans that have a direct impact
on investors and beneficiaries of the plans.
The MSRB has undertaken its Dodd-Frank responsibilities in a
deliberate and thorough manner, recognizing that many of these
financial professionals and products are falling under regulation for
the first time. With respect to the Dodd-Frank provisions that affect
the municipal market, but that come under the purview of other Federal
regulators, the MSRB has provided input and coordinated with other
municipal market authorities to create consistent and well thought-out
regulatory decisions.\9\ We would especially like to recognize the
Securities and Exchange Commission (SEC), the Financial Industry
Regulatory Authority and the Commodity Futures Trading Commission in
these coordination efforts.
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\9\ See, e.g., MSRB Comment Letter Re: SEC Proposed Rules on
Registration of Municipal Advisors, File No. S7-45-10 (February 22,
2011).
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Fiduciary Duty
I would now like to turn our attention to MSRB rulemaking efforts
since the Dodd-Frank Act became effective. The Dodd-Frank Act has
fundamentally altered the relationship of municipal advisors and
municipal entities. As of October 1, 2010, municipal advisors owe a
Federal fiduciary duty to their municipal entity clients under the
Dodd-Frank Act. The MSRB has proposed a rule and interpretive guidance
to provide the underpinning for this fiduciary duty.\10\ The MSRB's
interpretive guidance would provide that a municipal advisor has a duty
of loyalty to its municipal entity client, which requires the municipal
advisor to deal honestly and in good faith with the municipal entity
and to act in the municipal entity's best interests. This duty of
loyalty would also require municipal advisors to make clear, written
disclosure of all material conflicts of interest and to receive
written, informed consent from appropriate officials of the municipal
entity.
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\10\ MSRB Notice 2011-14 (February 14, 2011).
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The MSRB's interpretive guidance would also require municipal
advisors to exercise due care in performing their responsibilities to
municipal entity clients. That means that a municipal advisor should
not undertake a municipal advisory engagement for which the advisor
does not possess the degree of knowledge and expertise needed to
provide the municipal entity with informed advice. For example, a
municipal advisor should not undertake a swap advisory engagement or
security-based swap engagement for a municipal entity unless it has
sufficient knowledge to evaluate the transaction and its risks, as well
as the pricing and appropriateness of the transaction.\11\
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\11\ Section 4s(h)(5) of the Commodity Exchange Act, as amended by
the Dodd-Frank Act, requires that a swap dealer with a special entity
client (including States, local governments and public pension funds)
must have a reasonable basis to believe that the special entity has an
independent representative that satisfies these criteria, among others.
Section 15F(h)(5) of the Exchange Act, as amended by the Dodd-Frank
Act, imposes the same requirements with respect to security-based
swaps.
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We believe investors will benefit from ensuring that municipal
advisors act in their clients' best interest. Municipal securities
offerings borne from self-interested advice or in the context of
conflicting interests or undisclosed payments to third-parties are much
more likely to be the issues that later experience financial or legal
stress or otherwise perform poorly as investments, resulting in
significant harm to investors and increased costs to taxpayers.
Importantly, under the Dodd-Frank Act, ``municipal advisor'' was
defined to include guaranteed investment contract (GIC) brokers.\12\
That means that GIC brokers now have a Federal fiduciary duty to their
municipal entity clients and a duty of fair dealing to other clients,
as described below. The proposed MSRB interpretive guidance on
fiduciary duty would provide that they could not receive payments from
other parties in return for giving them favorable treatment in what is
supposed to be a competitive bidding process, even if they disclosed
such payments. This is a major increase in the arsenal of enforcement
agencies that, until now, have had to address this conduct through
their anti-fraud jurisdiction.
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\12\ Pub. L. No. 111-203 975, 124 Stat. 1922 (2010).
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We believe that the new Federal fiduciary duty, and the MSRB's
proposed guidance with respect to that duty arising from our new grant
of authority under Dodd-Frank, would have squarely addressed much of
the wrongdoing uncovered by the SEC, Internal Revenue Service and
Department of Justice in their major GIC bid rigging investigation \13\
had this Dodd-Frank provision been in place when the wrongdoing
occurred. In light of these allegations concerning the conduct of GIC
brokers, the MSRB Board of Directors will discuss whether additional
guidance specifically directed at such conduct is warranted.
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\13\ SEC Complaint para. 1, SEC v. J.P. Morgan
Securities LLP, Case No. 2:11-cv-03877 (D.N.J. July 7, 2011) (alleging
fraudulent bidding practices by J.P. Morgan Securities in at least 93
municipal bond reinvestment transactions); SEC Litigation Release No.
21956, Securities and Exchange Commission v. UBS Financial Services
Inc. (May 4, 2011) (alleging fraudulent bidding practices by UBS
Financial Services in at least 100 municipal bond reinvestment
transactions); In the Matter of Banc of America Securities LLP,
Exchange Act Release No. 63451 (December 7, 2010) (alleging fraudulent
bidding practices by Banc of America Securities in at least three
municipal bond reinvestment transactions) [hereinafter Bid Rigging
Enforcement Actions].
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Fair Dealing
MSRB Rule G-17 provides that, in the conduct of its municipal
securities and municipal advisory activities, each dealer and municipal
advisor must deal fairly with all persons and may not engage in any
deceptive, dishonest or unfair practice. This ``fair dealing'' rule is
key to defining the relationships of dealers and municipal advisors
with investors and issuers, and has served as the basis for numerous
enforcement actions.\14\ The MSRB's rule goes further than SEC Rule
10b-5 \15\ in that it imposes an affirmative duty to supply investors
and issuers with disclosure about their transactions. This duty exists
under the MSRB's rule even in the absence of fraud.
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\14\ See, e.g., In the Matter of J.P. Morgan Securities Inc., SEC
File No. 3-13673 (October 7, 2010) (providing a plan of final
distribution for the disgorgement and civil penalty paid by J.P. Morgan
Securities for violating MSRB Rule G-17 and other Federal securities
laws).
\15\ 17 C.F.R. 240.10b-5, 15 U.S.C. 78j (2010).
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Last fall, the MSRB reminded dealers of their fair dealing
obligations,\16\ including their duty to disclose to customers all
material facts known by the dealer and those reasonably accessible to
the market prior to or at the time of sale of a municipal security. The
MSRB also stated that firms must analyze and disclose credit risks and
other material information about a bond, such as redemption options or
features that would affects its tax status, in order to meet their fair
dealing obligations. For example, if the credit rating of a municipal
issuer was recently downgraded, the dealer must provide an investor
with this information. The MSRB made clear to the dealer community the
critical importance of sharing with investors such key information so
they are able to make the best possible decision based on their
individual circumstances and risk tolerance.
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\16\ MSRB Notice 2010-37 (September 20, 2010).
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As I mentioned earlier, Congress expressly directed the MSRB in the
Dodd-Frank Act to protect municipal entities.\17\ As one of the MSRB's
initial municipal advisor rules, the MSRB extended its fair dealing
rule, MSRB Rule G-17, to cover the actions of municipal advisors.\18\
The MSRB has proposed two pieces of interpretive guidance under Rule G-
17, which apply this basic principle of fair dealing to municipal
advisors and to underwriters of municipal securities in their
interactions with municipal entities, as well as with organizations
such as hospitals and colleges that borrow through municipal entities
(referred to in the statute as ``obligated persons'').
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\17\ Pub. L. No. 111-203 975, 124 Stat. 1918 (2010).
\18\ MSRB Notice 2010-59 (December 23, 2010).
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The MSRB's proposed interpretive guidance on fair dealing
obligations for underwriters \19\ states that representations made by
underwriters to issuers of municipal securities in connection with
municipal securities underwritings must be truthful and accurate. It
also requires an underwriter of a negotiated issue that recommends a
complex municipal securities financing (e.g., a financing involving a
swap) to disclose all material risks and characteristics of the
financing, as well as any incentives for the underwriter to recommend
the financing and any other conflicts of interest. The guidance also
contains pricing and compensation standards.
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\19\ MSRB Notice 2011-12 (February 14, 2011).
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We note that, if true, the fraudulent and deceptive conduct of some
major underwriters alleged to have occurred in actions brought by the
SEC and Department of Justice as a result of their GIC bid rigging
investigation \20\ would be considered a clear violation of Rule G-17
under this proposed interpretive guidance.
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\20\ Bid Rigging Enforcement Actions, supra note 12.
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The MSRB's proposed interpretive guidance on fair dealing
obligations for municipal advisors \21\ covers a municipal advisor's
duties to obligated persons in a municipal securities or financial
product transaction, as well as duties to municipal entities (such as
public pension funds) when the advisor is soliciting business from a
municipal entity on behalf of a third party. This guidance contains
disclosure and competency requirements, as well as prohibitions on
engaging in municipal advisory business in certain conflict of interest
situations, such as those involving kickbacks. This interpretive
guidance would offer protections to market participants when a stronger
fiduciary duty does not exist.
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\21\ MSRB Notice 2011-13 (February 14, 2011).
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A dealer's or municipal advisor's compliance with its fair dealing
obligations to municipal entities creates uniform practices and fair
pricing methods that improve market efficiency and have cascading
benefits to investors in terms of receiving a fair return on their
investment. We believe our revised fair dealing rule to be a pillar in
investor protection.
Pay to Play
As the first regulator to adopt a ``pay to play'' rule,\22\ the
MSRB recognized the potential for market abuse that can arise as a
result of market professionals using political contributions to
influence the award of business by public officials. The MSRB has
curbed potential abuses by underwriters of municipal securities that
made political contributions to win business and is seeking to do the
same for municipal advisors.
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\22\ MSRB Rule G-37 was adopted by the MSRB in 1994 due to concerns
about the opportunity for abuses and the problems associated with
political contributions by dealers in connection with the award of
municipal securities business, known as ``pay to play.'' See MSRB
Reports, Volume 14, Number 3 (June 1994).
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Municipal advisors that seek to influence the award of business by
Government officials by making or soliciting political contributions to
those officials distort and undermine the fairness of the process by
which Government business is awarded. These practices can harm
municipal entities and their citizens by resulting in inferior services
and higher fees, as well as contributing to the violation of the public
trust of elected officials. The MSRB has proposed a rule that would,
for the first time, regulate pay to play activities of firms and
individuals that advise municipal entities, such as State and local
governments and public pension plans, on municipal securities and
municipal financial products, including derivatives.\23\ The rule would
also cover firms and individuals that solicit investment advisory
business from municipal entities, such as public pension plans, on
behalf of others.
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\23\ MSRB Notice 2011-04 (January 14, 2011).
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Draft MSRB Rule G-42 would require quarterly disclosure of certain
campaign contributions and would prohibit a municipal advisor from:
Engaging in ``municipal advisory business'' with a
municipal entity for compensation for a period of time
beginning on the date of a non-de minimis political
contribution to an ``official of the municipal entity'' and
ending 2 years after all municipal advisory business with the
municipal entity has been terminated; and
Soliciting third-party business from a municipal entity for
compensation, or receiving compensation for the solicitation of
third-party business from a municipal entity, for 2 years after
a non-de minimis political contribution to an ``official of the
municipal entity.''
Furthermore, draft MSRB Rule G-42 would prohibit municipal advisors and
municipal advisor professionals from:
Soliciting contributions, or coordinating contributions, to
officials of municipal entities with which the municipal
advisor is engaging or seeking to engage in municipal advisory
business or from which the municipal advisor is soliciting
third-party business;
Soliciting payments, or coordinating payments, to political
parties of States or localities with which the municipal
advisor is engaging in, or seeking to engage in, municipal
advisory business or from which the municipal advisor is
soliciting third-party business; and
Committing indirect violations of Rule G-42.
MSRB pay to play restrictions have served as a model for Federal
and State regulators imposing restrictions on pay to play activities in
other areas and play a vital role in preserving market integrity. The
MSRB has served as a key resource to such other regulators as they have
developed and administered their rules.
Gifts
Gifts to employees controlling the award of municipal securities
business by market professionals can similarly harm investors. The MSRB
limits these gifts by dealers and recently proposed to extend the
restrictions of MSRB Rule G-20 to municipal advisors.\24\ Just as the
existing rule helps to ensure that dealers' municipal securities
activities are undertaken in arm's length, merit-based transactions in
which conflicts of interest are minimized, amendments to Rule G-20
would help to ensure that engagements of municipal advisors, as well as
engagements of dealers, municipal advisors, and investment advisers for
which municipal advisors serve as solicitors, are awarded on the basis
of merit and not as a result of gifts made to employees controlling the
award of such business.
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\24\ MSRB Notice 2011-16 (February 22, 2011).
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Supervision
The establishment of a basic supervisory structure for municipal
advisors is particularly important as the MSRB adopts new rules for
municipal advisors that municipal advisors must understand and comply
with in order to avoid possible enforcement actions and to effectively
put in place practices that serve to protect investors. The MSRB
recently requested comment on a supervisory rule, draft MSRB Rule G-44,
to require that each municipal advisor firm establish a supervisory
structure to oversee compliance with applicable MSRB and SEC rules.\25\
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\25\ MSRB Notice 2011-28 (May 25, 2011).
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Draft Rule G-44 would require a municipal advisor to establish and
maintain a system to supervise the municipal advisory activities of
each associated person designed to achieve compliance with applicable
rules. Draft Rule G-44 would also require municipal advisors to adopt,
maintain and enforce written supervisory procedures designed to ensure
that the conduct of the municipal advisory activities of the municipal
advisor and its associated persons are in compliance with applicable
rules.
Board of Directors
The new composition of the MSRB's Board of Directors has assisted
us in carrying out our regulatory actions over the past year. The Dodd-
Frank Act requires the MSRB's governing Board to be majority-public and
to include municipal advisors.\26\
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\26\ Pub. L. No. 111-203 975, 124 Stat. 1917 (2010).
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On October 1, 2011, the MSRB seated a 21-member Board with a
majority of public members, including three municipal advisors.\27\ The
Board also includes representatives of issuers and investors, as well
as members representing securities firms and banks. We have a newly
structured majority-public Nominating Committee chaired by a public
member.
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\27\ MSRB Press Release, MSRB Assumes Expanded Mission and
Establishes Public Majority Board of Directors (October 1, 2010).
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We believe this Board of Directors reflects the benefits of a self-
regulatory organization and, at the same time, the wisdom of
increasingly diverse and public membership. Our rulemaking--and the
public's interest--has benefited from the many perspectives offered by
our Board members. The Board vigorously debates issues, carefully
considers the experience and insight of each of its members and then
proceeds with the best possible course of action. We believe the
progress we have made over the last 9 months in further protecting the
market has been unprecedented.
The rules I have mentioned are just a small part of the regulatory
backbone that helps support a fair and efficient municipal market.
Professional Qualifications
It is vital to our mission that municipal market professionals can
competently provide their services to investors and municipal entities.
The MSRB Professional Qualification Program fosters competency of
municipal professionals and compliance with MSRB rules through required
examinations and continuing education. The Dodd-Frank Act requires the
MSRB to set standards of professional qualification for municipal
advisors.\28\ The MSRB has been conducting outreach events and focus
groups to gather input from municipal advisors and others about the
development of a professional qualification examination to assess the
competency of entry-level municipal advisors.
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\28\ Pub. L. No. 111-203 975, 124 Stat. 1919 (2010).
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The MSRB recently organized a municipal advisor examination working
group to consider all comments received by the MSRB, assess
commonalities in municipal advisory activities and provide additional
input. The working group expects to survey registered municipal
advisors about the proposed examination content in late 2011 and use
the results of the survey to prepare a draft examination content
outline. We will continue to keep interested parties apprised of our
progress in this area as we proceed.
EMMA and Market Transparency
I would now like to discuss another top priority of the MSRB--
market transparency. Beginning as a pilot program in 2008, our EMMA
system, at www.emma.msrb.org, has transformed the transparency of the
municipal market. Any investor can now access from anywhere hundreds of
thousands of disclosure documents and real-time trading information on
1.5 million outstanding municipal bonds. We provide all of this
information to the public for free.
EMMA was created for the purpose of providing retail investors with
easy access to key market information that was previously unavailable
or difficult to find. Retail investors are heavily involved in the
municipal market, with retail trades (generally viewed as trades of
$100,000 or less) accounting for over 80 percent of the approximately
7.3 million customer transactions in municipal securities over the past
year.\29\ The MSRB's EMMA Web site supports well-informed
decisionmaking by these investors.
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\29\ This statistical information may be found by searching EMMA's
Market Statistics tab at http://emma.msrb.org/MarketActivity/
ViewStatistics.aspx.
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Over the past year, the MSRB has greatly expanded the amount and
type of information available to investors on EMMA. The MSRB began
providing interest rate information on EMMA about auction rate
securities (ARS) and variable rate demand obligations (VRDO) in 2009,
after instability in these markets raised significant disclosure and
market transparency concerns. Today EMMA remains the only source of
current, market-wide interest rates for variable rate securities
available to the general public. In May 2011, the MSRB enhanced EMMA to
provide public access to key ARS auction and VRDO liquidity
information, including actual copies of liquidity documents such as a
letter of credit. Providing investors with easy access to these
documents and data increases their ability to make informed decisions
about investing. The MSRB testified before you in 2009 regarding our
plans to increase the information and documents available about ARS and
VRDOs \30\ and I am happy to report that this increased transparency
has been accomplished.
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\30\ Transparency and Regulation in the Municipal Securities Market
Hearing Before the U.S. Senate Committee on Banking, Housing, and Urban
Affairs (2009) (statement of Ronald A. Stack, Chair, Municipal
Securities Rulemaking Board).
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EMMA also is a tool for issuers to communicate important
information about their bonds and their finances to investors. The MSRB
received requests from State and local government issuers to provide
the ability for issuers to voluntarily post preliminary official
statements to EMMA. We are happy to announce that, as of May 2011, we
have made this possible. Preliminary official statements can provide
potential investors with the details of a new issue before it comes to
market. Issuers in several States have already taken advantage of this
new EMMA feature--including South Carolina, Utah, Kentucky, Florida and
Wisconsin--and we expect its use to increase over time.
As part of its investor protection rules, the MSRB requires timely
disclosure by our regulated entities and promotes good continuing
disclosure practices by issuers. Issuers provide some types of
continuing disclosure information under SEC Rule 15c2-12. The MSRB has
added the ability for issuers to submit numerous voluntary disclosures
that go beyond this SEC baseline. Most recently, the MSRB enhanced EMMA
to allow issuers to submit information about the timing and accounting
standard used to prepare annual financials. This helps investors
acquire a more complete picture of the issuers and issues in which they
are investing. As EMMA provides a centralized location for disclosures,
investors and others interested in the disclosure practices of issuers
and trading activity of bonds can easily use EMMA to access and compare
the available information.
The MSRB will continue to improve EMMA. This fall, EMMA will
display credit ratings from one or more of the Nationally Recognized
Statistical Rating Organizations. These ratings will be available on
the EMMA Web site, for free, and updated in real-time.
Conclusion
The municipal market funds much of this nation's health, education
and transportation infrastructure. It is the MSRB's role to balance and
protect the competing interests in this public-purpose market. Where we
have the jurisdiction and ability to act, the MSRB has raised the bar
on professional conduct by financial professionals and advanced market
transparency in many significant ways. The benefits of these efforts
ultimately flow to the investor and taxpayer.
The MSRB is dedicated to a thoughtful, thorough rulemaking process
that involves significant input from municipal market participants. We
depend on input from investors, issuers, industry members and others to
ensure MSRB rules are timely and appropriate. We believe that this
widespread participation in rulemaking makes both the process and the
product at the MSRB as balanced as possible and in the best interests
of investors and municipal entities.
We believe we not only have a responsibility to write regulations
and provide transparency, but also a corresponding responsibility to
educate market participants on the progress of these efforts. Since the
Dodd-Frank Act, the MSRB has conducted outreach events across the
country to provide a forum for education and input regarding our new
mission and jurisdiction. We appreciate the opportunities provided by
the Dodd-Frank Act to improve the municipal market and look forward to
continuing to work with Congress, industry members, issuers and
investors with this goal in mind.
I thank you again for the invitation to speak today and will take
any questions you may have.
______
PREPARED STATEMENT OF HARVEY L. PITT\1\
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\1\ Mr. Pitt is the Chief Executive Officer of Kalorama Partners,
LLC, and its law-firm affiliate, Kalorama Legal Services, PLLC. Prior
to founding the Kalorama firms in 2003, Mr. Pitt served as Chairman of
the U.S. Securities and Exchange Commission (2001-2003), was a senior
corporate law firm partner (1978-2001), and served for over 10 years as
a member of the Staff of the SEC (1968-1978), the last 3 years of which
he served as the Agency's General Counsel.
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Former Chairman, Securities and Exchange Commission
July 12, 2011
Introduction
Chairman Johnson, Ranking Member Shelby, Members of the Committee:
I am pleased to appear before you today to respond to this
Committee's invitation to testify about the critical issue of
``Enhanced Investor Protection After the Financial Crisis.'' The
financial crisis that began in 2007-2008 was, as we know only too well,
one of the worst economic collapses this Country has experienced. The
failures that led to that collapse are manifold, but principal among
them, in my view, was the failure of our regulatory system (and
financial regulators) to respond effectively, efficiently and with
alacrity to both the warning signs that a crisis was imminent, and to
cabin what eventually became a full-blown crisis.
Thus, I strongly believe this Country needed (and still needs) to
reform its financial regulatory apparatus, and that was clearly the
impetus behind the adoption and enactment of the Dodd-Frank Wall Street
Reform and Consumer Protection Act (``D-F''). The Committee has
specifically requested that testimony today focus on Titles IV and IX
of D-F, which were intended, among other things, to enhance ``investor
protection.'' While Congress' intent in passing D-F was laudable, and
while there was a compelling need to reform our financial regulatory
system, D-F unfortunately did not provide the regulatory reform that
our financial and capital markets, and those who invest, so urgently
needed, and still require.
Notwithstanding my belief that D-F falls short of what we need, I
believe the principal effort at this point should be to figure out what
it will take to make the substance of D-F workable. Thus, my testimony
is directed at the changes needed to enable D-F to fulfill its goals,
without incurring many of the unintended consequences that I believe
plague so much of this legislation. The views I set forth are solely my
own, formed on the basis of an aggregate of over 43 years experience in
the financial and capital markets, both as a regulator, as a counselor
to those in the financial services industry and, for the past 8 years,
as the Chief Executive Officer of Kalorama Partners, LLC and its law-
firm affiliate, Kalorama Legal Services, PLLC.\2\ My views do not
reflect the views of any past or current clients of the Kalorama firms,
and do not reflect the views of the SEC.
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\2\ As a matter of policy, the Kalorama firms do not engage in
adversarial efforts vis-a-vis the SEC; rather, they assist companies,
firms, governmental entities and individuals that are committed to
enhancing their fidelity to important fiduciary and governance
principles, internal controls and compliance programs.
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Summary
There is no question that, in the wake of the financial crisis that
began in 2007-2008, financial regulatory reform was needed. We needed a
more nimble regulatory regime. However, the legislation passed nearly 1
year ago did not provide the reform the Country needed. While this is
not the forum in which to revisit all the problems with D-F, in brief,
I believe the Country required that financial regulatory reform provide
three critical elements:
A steady flow of significant, current information on the
activities of anyone playing a meaningful role in our financial
and capital markets;
The imposition on Government of a duty to analyze the
information it receives to discern trends and developments,
along with the obligation to publish, generically, the trends
and developments Government discerns; and
The grant to the Government of the ability to create so-
called tripwires, so that as trends start to become apparent,
Government can halt those trends until it determines (subject
to appropriate Congressional oversight) whether these trends
are potentially harmful and, if so, what steps should be taken
to cabin their further development.
D-F did not achieve these goals. Worse, the Act is unduly complex,
adds more layers of regulatory bureaucracy to an already over-bloated
bureaucracy, makes financial regulation more cumbersome and less nimble
than it already was, and contains the seeds for destroying the
independence of three regulators whose independence was always a
strength of our existing regulatory system-the Federal Reserve Board,
the SEC, and the CFTC.\3\
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\3\ Through the creation of the Financial Stability Oversight
Council, which is led by the Treasury Secretary, the independent views
of the Fed, the SEC and the CFTC, as well as their functions, can
effectively be overridden.
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Notwithstanding these impediments, the SEC and other financial
regulators have been working assiduously to adopt hundreds of new
rules, and produce a plethora of written studies, often without being
afforded the necessary time to achieve the demands imposed by D-F,
including rules to implement provisions under Titles IV and IX of D-F--
the Committee's current focus--as well as Title VII and other
provisions of the Act, and many more rules are in process. While the
SEC has valiantly attempted to address, through its rulemaking, many of
the concerns that I and others have raised regarding the potential for
mischief contained within the 2,300+ pages of D-F, there is only so
much the Agency can, or should, do once Congress has expressed its
judgment on important policy issues.
Without attempting to be exhaustive regarding the myriad problems I
perceive in Titles IV and IX of D-F, there are four provisions that
particularly deserve this Committee's attention if D-F is to serve its
intended investor protection purposes:
The expansion of the SEC's examination and regulatory
responsibilities over hedge funds, private equity firms, and
some venture capital firms (as well as enhanced obligations
regarding credit ratings agencies) that the SEC cannot possibly
fulfill given the current wording of D-F and the lack of
appropriate resources;
The establishment of a whistleblower ``bounty'' program
that:
creates negative incentives that threaten to undermine
corporate compliance programs;
threatens to make every ``tip'' of which both the SEC and
private sector firms become aware a ``Federal case''; and
sets the SEC up for failure by likely causing it to be
inundated with a slew of ``tips,'' without giving it the
resources necessary to ``separate the wheat from the chaff'';
Corporate governance provisions that:
intrude on the traditional province of State corporate
law;
favor certain special interests at the expense of rank
and file shareholders; and
impose significant unanticipated costs on corporations,
and thus shareholders; and
Provisions that establish a new Office of Investor Advocate
that:
Undermine the authority not only of the Staff but of the
Commission itself with respect to both enforcement and
rulemaking decisions; and
Create a potentially divisive source of internal second-
guessing that may actually slow down, rather than facilitate,
regulatory reforms that protect retail investors.
Discussion
1. Increasing the SEC's Examination Responsibilities
As a result of Title IV of D-F, and especially D-F 402 & 403, the
SEC's jurisdiction over hedge funds, private equity funds and certain
venture capital firms has increased exponentially. While there is a
paucity of precise data, it appears that, as of the end of 2009, there
were over 9,000 hedge funds in existence.\4\ The Commission already
oversees approximately 11,000 registered investment advisers and 6,000
registered securities broker-dealers, beyond which D-F imposes on the
SEC new oversight responsibilities for credit ratings agencies,
municipal securities dealers and a host of swaps professionals and
participants.
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\4\ See IFSL Research, ``Hedge Funds 2010'' (Apr. 2010), available
at http://www.scribd.com/doc/36124567/Hedge-Funds-2010.
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Putting to one side the substance of D-F's creation of a new
regulatory regime for hedge funds and other private fund investment
advisers,\5\ the grant of this authority begs the question: How will
the SEC exercise its oversight and compliance examination
responsibilities once it has registered these new entities? It seems
rather clear that the SEC's own compliance and examination efforts
cannot match the number of entities requiring examination, or the
sophistication and diversity of investment strategies with which the
SEC's Staff will be confronted. Despite promises of new funding that
were made when D-F was first enacted, the current budget crisis makes
it impossible that the Commission will have sufficient resources to
enable it to:
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\5\ Because hedge funds were, initially, marketed only to highly
sophisticated investors, in denominations that placed these funds
beyond the reach of ordinary investors, it was not deemed sufficient to
require detailed regulation of those who managed these funds. As hedge
fund advisers have become publicly traded entities, and pension funds
have turned more and more frequently to hedge funds to increase their
returns, this justification for the absence of regulation disappeared.
But, no nexus has ever been suggested between the economic crisis that
began in 2007-2008 and the market/investment activities of hedge funds.
Develop the necessary expertise to permit it to examine an
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additional 9-10,000 new entities subject to its jurisdiction;
Deploy such expertise as it has to perform regular
compliance examinations; or
Provide investors with appropriate confidence that the
funds in which they invest are subject to extensive compliance
oversight by the Federal Government.
In February 2003, under my direction, the SEC proposed to require
all investment advisers to undergo an exemption every year, or in the
case of smaller advisers, every 2 years, by an independent, expert,
private-sector entity that would perform a detailed compliance
``audit'' akin to the annual financial audits performed by independent
outside public accounting firms.\6\ The Commission would define
requisite independence and expertise, and would dictate the substance
of the annual (or biennial) compliance audit, and these audits would
result in the preparation of a detailed report of findings that would
be submitted both to the SEC and to the governing board of the funds
whose advisers are examined.
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\6\ See Compliance Programs of Investment Companies and Investment
Advisers, Investment Company Act Rel. No. 25925, Investment Advisers
Act Rel. No. 2107, 79 SEC Docket 1696 (Feb. 5, 2003).
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Although this is a proposal that could address the serious problems
that inhere in the SEC's existing compliance examination process, this
proposal--or anything comparable--has not yet been adopted by the
Commission. It is, in my view, long overdue, and should be mandated by
Congress, to reduce the likelihood of future ``Madoff-like''
situations.\7\
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\7\ ``Enlisting'' third-party expert examiners is not a guarantee
against future Madoffs, but it will equalize the sophistication gap
that exists between the young men and women who perform examinations
for the SEC, on the one hand, and the experienced money managers whose
operations the SEC Staff must examine.
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2. Whistleblower Provisions
D-F 922 creates a new SEC whistleblower program that was intended
to increase both the number and quality of ``tips'' received by the SEC
from anyone who becomes aware of ``possible'' misconduct that could
adversely affect our capital markets. It cannot be gainsaid that a
well-designed whistleblower program that achieves the goal of providing
the Commission with better access to quality indications of potential
wrongdoing is a proposal that could benefit investors enormously. But,
as D-F was enacted, this provision threatens to undermine corporate
governance, internal compliance and the confidence of public investors
in our heavily regulated capital markets.
a. Impact on Corporate Governance and Internal Compliance Programs
Over the last half-Century, great strides have been taken to
provide investors with the most valuable first-line of defense against
securities fraud and other forms of misconduct--internal corporate
governance has been improved to ensure that corporate employees
inculcate and adhere to proper values, while internal compliance
processes at the firms of securities professionals have been
strengthened and expanded to nip nascent potential frauds in the bud.
While it is undoubtedly beneficial to encourage those who become aware
of possible misconduct to report to their firms and corporations any
perceived instances of misconduct, and to encourage those firms and
corporations to inquire into perceived instances of misconduct, D-F and
the rules it compelled the SEC to adopt threaten to have exactly the
opposite effect.
D-F, and the SEC rules adopted under it on May 25, 2011, may
incentivize tipsters to submit unsupported--and possibly speculative or
even frivolous--``tips'' directly to the SEC, rather than to the
companies or firms to which their ``tips'' relate. More significantly,
the system created threatens to divert the SEC Staff's attention away
from more productive investigations. This is a logical outcome of the
fact that the D-F whistleblower provisions give formal legal rights to
those who claim their ``tips'' were significant factors in the SEC's
ability to recover monetary payments in excess of $1 million, as a
result of alleged securities-related misconduct. I believe that the
potentially huge amounts at stake--a bounty ranging from between 10 and
30 percent of the monetary sanctions recovered in any successful
enforcement action that resulted from the tip--and D-F's unfortunate
premium for being ``first in line,'' will at best undermine, and at
worst eviscerate, companies' existing internal compliance programs.
Sound risk management practices as well as legal requirements, such
as the Sarbanes-Oxley Act (``S-Ox''), place great emphasis on
companies' implementation of robust compliance programs to help ensure
that wrongdoing is prevented or detected, and if detected, stopped and
remedied as quickly as possible. Companies with strong compliance
programs may be able to detect and remedy misconduct more quickly and
more effectively than the SEC can, given the Commission's many other
responsibilities and its need to comply with the legal formalities
required of Government actors. Public investigative and enforcement
processes simply take more time than internal action.
However, D-F 922 and the SEC's implementing rules do not require
an employee first to report internally the suspected wrongdoing.
Instead, they create overwhelming financial incentives to bypass
internal reporting mechanisms and requirements, and go directly to the
SEC with their tips. As a result, they may effectively deny companies
the opportunity to detect and take prompt remedial action in response
to internally reported tips from employees. They also reduce the likely
quality of any tips received by placing more importance on speed than
factual support. By diverting tips and complaints from internal
compliance and legal channels to the SEC, the whistleblower provisions
paradoxically may result in violations continuing and becoming more
serious. This is the very opposite of the result intended by Congress
in enacting both S-Ox and D-F.
In response to comments prior to the promulgation of the final
rules, the Commission acknowledged the potential of 922 to undermine
internal compliance programs, and adopted certain measures that are
intended to ``encourage'' employees to report wrongdoing to their
compliance or legal departments, before or at the same time they report
to the SEC. These are:
A provision granting an employee whistleblower status as of
the date the employee reports the information internally, if
the employee provides the same information to the SEC within
120 days, thereby affording employees the ability to report the
alleged wrongdoing internally first, without losing their
``spot in line'' for a possible award from the SEC.
A provision that credits employees who report their
suspicions internally first with information obtained from a
company's internal investigation, that resulted (in whole or in
part) from information that was reported internally by the
whistleblower, even if the internal report, by itself, would
not have been ``sufficiently specific, credible, and timely''
to ``commence or reopen an [SEC] investigation . . . ''
A provision permitting the SEC to consider initial internal
reporting as a factor weighing in favor of larger whistleblower
awards. This provision, however, is permissive, not mandatory.
Indeed, the failure to report suspicions internally will not
necessarily result in a lower bounty, and whistleblowers who
fail to report internally are still eligible to receive the
highest possible bounty--30 percent.
I do not believe these measures, taken together, create sufficient
affirmative incentives to ensure that employees will actually report
their suspicions internally first. Tipsters who bypass internal
compliance procedures and report to the SEC in the initial instance--
even after they become aware of an internal investigation about the
alleged wrongdoing--are still eligible for a 30 percent award, and
tipsters who do report internally first are not assured of receiving
the highest level award. Further, with the lure of million-dollar
bounties, it is unlikely that potential whistleblowers will consider
(assuming they understand) the prospect that they will be credited with
the additional information generated by an internal investigation
initiated as a result of an internal report. I believe that,
notwithstanding the SEC's efforts to incentivize initial internal
reporting, the overwhelming majority of tipsters will report directly
to the SEC, bypassing their companies' internal reporting mechanisms
and compliance departments.
Other provisions of the rules exacerbate the potential for damage
to corporations' existing internal compliance programs. Specifically,
the exclusion from eligible whistleblower status of internal compliance
and internal audit personnel--including lawyers who receive tips in the
context of a privileged attorney-client communication--is not
meaningful. This is because the ``exclusion'' carves out, and thus
makes eligible for whistleblower status, internal compliance, internal
audit and legal personnel who claim ``a reasonable basis to believe
that disclosure of the privileged information is necessary to prevent
substantial injury to the financial interest or property of
investors.''
As both Commissioners Casey and Paredes have observed, these
exceptions effectively swallow the rule. Consequently, as a practical
matter, such personnel are eligible to receive a bounty without taking
any further internal action; like all other persons eligible for
whistleblower status, these persons are not subject to a prior internal
reporting requirement, despite being the very individuals directly
charged with responsibility for the company's internal compliance,
internal audit and legal functions.
By effectively negating the exemption of internal compliance and
audit personnel from eligibility for whistleblower status, the rules:
(1) create additional disincentives for both business heads and other
employees to bring problems to the attention of internal compliance
personnel, for fear that they will turn around and go directly to the
SEC; (2) engender mistrust of internal compliance and audit personnel;
and (3) otherwise create internal divisiveness between business lines
and internal control support functions.
b. Transforming Every ``Tip'' into a Federal Case
Whether or not a tip is first reported to the tipster's employer, a
likely consequence of this provision of D-F will be to convert every
tip into a significant ordeal for those companies that learn of them.
This is so for several reasons.
Depending on the volume of tips received, but even if the
Agency is not inundated with tips, it is in the SEC Staff's
interest to refer every tip to the company or firm to which the
tip relates, for initial review. In that way, the SEC Staff
will not run the risk that they may mistake a valuable tip they
receive for something of no real consequence.
Once a tip is referred to a company--either by the tipster
or by the SEC Staff--companies will have little choice but to
elevate every tip to a higher level of attention than would
otherwise be appropriate. After all, if a company investigating
a tip wants to avoid having to go through at least two
investigations--one by the company itself, and one by the SEC
Staff--it will want to be able to document precisely how a
spurious tip misses the mark in reality. This will add
extensively to the cost of handling these kinds of tips,
whether or not the tip has any merit at all.
Because the tipster will have legal rights to recover money
if it turns out the tip has merit and leads to a recovery in
excess of $1 million, the company may feel the necessity of
expending undue resources on even frivolous tips, since a
company determination the tip is frivolous that persuades the
SEC Staff may result in litigation brought to contest the
company's bona fides in reaching it conclusion that the tip had
no merit.
This is a hidden ``cost'' of this provision of D-F that will
elevate the price extracted for those who seek, in good faith, to
comply with the statute.
c. Impact on SEC Resources and Efficiency
In addition to the concerns I have about the whistleblower
provisions' potentially devastating consequences for internal
compliance programs, I am also concerned about the potentially impact
of these provisions on the SEC itself. The prospect of huge bounties
merely for reporting a ``possible'' violation will spur an excessive
flow of whistleblowing claims to the SEC, with people reporting claims
based on weak or speculative information or reporting wholly spurious
claims ``just in case.'' And, while responsible counsel for
whistleblowers could serve as effective gatekeepers, there is no
assurance they will do so. D-F 922 specifically provides that any
whistleblower, who makes a claim, may be represented by counsel, and
must be represented by counsel if he or she wishes to submit the claim
anonymously.
It is therefore not surprising that the Commission, in its adopting
release, estimated that it will receive approximately 30,000 tips,
complaints and referral submissions each year. Further, despite the
extraordinary number of tips expected, neither the statute nor the
rules ensure that the quality of tips is commensurately high. To the
contrary, as the adopting release acknowledges, the standards for
qualifying for a bounty under the False Claims Act are much higher than
those under D-F. Yet, the SEC has been given relatively few additional
resources with which to ``separate the wheat from the chaff,'' and has
set aside $450 million to fund a pool from which rewards can be paid.
D-F requires the SEC to establish a new, separate office within the
agency to administer and enforce the whistleblower provisions. This new
office will report annually to House and Senate committees on its
activities, whistleblower complaints, and the SEC's response to such
complaints. However, due to funding constraints, that office is being
staffed out of existing SEC personnel--diverting them from other
responsibilities.
In short, the SEC is being set up for failure. That serves no one's
interests, let alone that of investors. Somewhere, somebody should step
back and say, ``We are piling all these responsibilities on, creating
all these new provisions, but how do we expect the agency to cope?''
The SEC has been given more rulemaking, more studies and more demanding
responsibilities under D-F than any other financial regulator, but was
denied what many other financial regulators have--the ability to self-
fund its operations (with accountability to Congress for the policy
decisions it makes). The SEC should be given this authority, provided
there is full and complete accountability to Congress on the uses to
which the SEC proposes to put the funds available to it through this
mechanism.
d. Proposed Amendment
On May 11, 2011, Rep. Michael Grimm of New York circulated draft
legislation that would amend D-F to require a whistleblower to first
report fraud through an internal compliance program before being
eligible to receive an award under the program. I strongly support such
an amendment. Indeed, I would go further and advocate that the ``carve-
out'' from the exemption for whistleblower eligibility for internal
compliance, audit and legal personnel be tightened, if not completely
eliminated.
2. Corporate Governance
a. Proxy Access.
D-F's proxy access provisions are intended to promote shareholder
democracy by requiring companies to include board candidates in
management's proxy materials if nominated by shareholders holding at
least 3 percent of the voting equity for at least 3 years. As a
practical matter, however, the proxy access provisions, which have been
stayed by the SEC pending the outcome of litigation over the validity
of the Commission's rule, give disproportionate influence to certain
shareholder constituencies--such as unions and pension funds--that have
special interests that may be different from, or even adverse to, rank
and file investors. Given that these special shareholder constituencies
already usually possess significant leverage to affect corporate policy
through the power of collective bargaining, it is not clear why
providing them with an additional means of advancing their interests
promotes shareholder democracy.
And, it follows that, if the benefits of the new rule were
overstated, the likely costs of the rule were not properly considered.
Contested elections are expensive, and shareholders ultimately bear
their cost. While the SEC said in its adopting release that it expects
about 51 proxy contests a year as a result of the new rule, that would
mean a drop from the 57 contested corporate elections in 2009. It is
not clear how a rule designed to facilitate shareholder nominees can
lead to fewer contested elections?
While recognizing that some companies likely would oppose a
particular shareholder nominee, and incur the consequent expenses, the
Commission assumed that these costs would be limited because the
directors' fiduciary duties would prevent them from using corporate
funds to resist shareholder director nominations in the absence of any
good-faith corporate purpose. Even if this assumption were true in an
abstract sense, there is no way to quantify it sufficiently to support
the Commission's estimates of the number of proxy contests likely to
result from the new rule.
Quite apart from the flaws in the Commission's cost-benefit
analysis, the new rules reflect an unnecessary and ill-advised change
in shareholders' rights, by pre-empting State law--the traditional
source of such rights--in favor of imposing a new, one-size-fits-all
regime on corporations from which they cannot opt out, even if their
shareholders would prefer to do so. In 1934, when this Committee's
predecessors passed the Securities Exchange Act, power over proxy
contests was divided between the Federal Government and the States.
State law determines what substantive rights a corporate shareholder
may claim, while Federal regulation was intended to govern the
disclosure applicable to, and the mechanics of, shareholder votes.
In stark contrast, this provision of D-F turns the traditional
situs of legal authority over shareholder voting power on its head.
And, it ignores the most efficient ways to have resolved the thorny
issue of proxy access:
Given the current ubiquitous state of computer facilities,
proxy materials should no longer be required to printed and
mailed to corporate shareholders. Instead, the Commission
should permit proxy solicitations to occur utilizing electronic
communications. This change alone would diminish much of the
effort on the part of corporate insurgents to utilize
management's proxy materials to further their own policy
choices.
Even in the absence of a shift to electronic proxy
solicitations, all the SEC need do is provide that shareholders
have the right to amend their corporation's by-laws in whatever
way State law permits, including an amendment to permit
whatever form of proxy access the requisite number of
shareholders approves. By dictating the mechanics of how this
issue would be presented to shareholders (in particular,
limiting the number of such proposals as well as the size and
length of shareholdings entitling a shareholder to make such a
proposal in management's proxy materials), the SEC has a
relatively non-controversial way to resolve the thorny issue of
proxy access without turning the supremacy of State law over
shareholder voting rights on its head.
This approach would take advantage of changes to State laws
regarding proxy access. In 2007, the Commission considered
amending Rule 14a-8(i)(8) to permit shareholders to propose
binding shareholder resolutions to amend a company's by-laws to
require the company to grant proxy access. Since 2007, the
Delaware General Corporation Law and the ABA's Model Business
Code have been amended to include provisions that explicitly
permit proxy access bylaws and proxy reimbursement bylaws.
This would have been (and still would be) an appropriate
approach to proxy access. An enabling proxy access rule would
avoid discriminatory distinctions among shareholders--
potentially pitting self-interested groups, like unions and
pension funds, against the average rank and file investor--in
favor of true shareholder suffrage. Such an approach would
facilitate companies' and shareholders' State-given rights to
determine the processes that govern the nomination and election
of directors, based on their unique circumstances. This
approach would also, of course, facilitate shareholders'
ability to avail themselves of the rights afforded by those
processes.
b. Say-on-Pay
D-F 951 requires public companies to solicit non-binding
shareholders' votes at least once every 3 years on the compensation of
their highest paid executive officers. This new requirement has been
referred to as say-on-pay. The first proxy season with say-on-pay votes
has passed, and the overwhelming majority--88 percent--of these votes
were positive, with more than 80 percent of these resolutions garnering
at least 80 percent positive votes.
However, shareholders in at least 39 companies voted ``no'' on
executive compensation. At least six of these ``no'' votes have been
followed by derivative claims against those companies and their boards,
claiming the pay packages awarded effectively breach the fiduciary
duties owed to shareholders who have rejected the specific executive
compensation involved, as well as corporate waste, in awarding the
rejected pay packages. Other ``investigations'' have been announced
into the approval of pay packages that presumably will lead to
litigation.
The first wave of post-say-on-pay lawsuits lends credence to the
warnings of those who predicted that the provision would lead to
increased shareholder litigation, despite the express provision in D-F
951(c) that the results of a say-on-pay vote do not create or imply
any additional fiduciary duties on the part of the company's board, nor
change the scope of any existing fiduciary duties. While most legal
commentators expect these suits to fail, given not only the language of
951(c) but also the high burden of proof set by the corporate law of
most States with respect to breaches of fiduciary duty and corporate
waste in the area of executive compensation, that only makes the
litigation costs that say-on-pay is likely to impose on corporations--
and thus their shareholders--even harder to justify.
3. Office of the Investor Advocate
Another example of D-F's unintended consequences is found in 915,
its directive that the SEC establish an Office of the Investor
Advocate. Putting to one side the fact that it is the SEC as a whole
that is the ``Investor's Advocate,'' this provision contains the seeds
of unnecessary conflict and adversarial posturing that will, ultimately
redound to the disadvantage of investors. The statute empowers the
Investor Advocate publicly to criticize and challenge agency actions or
inactions, without any obligation to seek the input of--or even give
notice to--the agency officials whose judgments may be publicly
challenged.
Moreover, at a time that the SEC's resources are strained to the
limit (and beyond) by the imposition of D-F's other mandates, coupled
with the denial to the SEC of the ability to self-fund (but with
accountability to Congress), the Investor Advocate is expressly
entitled to retain or employ independent counsel--that is, counsel not
already a part of the SEC's staff--as well as its own research and
service staff, as the Investor Advocate deems necessary to carry out
the duties of the office. It is true that D-F 915 requires the
Investor Advocate to ``consult'' with the SEC's Chairman before making
any such expenditures, but there is no requirement that the SEC
Chairman's views be given any deference whatsoever.
In short, the statute creates an independent bureaucracy within the
SEC that is inherently adversarial to both the Commission and its other
Staff, rather than collaborative. Indicative of the adversarial nature
of this position is the requirement imposed on the Commission to
establish procedures requiring a formal response to all recommendations
submitted to the Commission by the Investor Advocate. Such responses
must be received within 3 months, and then trigger the Investor
Advocate's ability to criticize the Commission's or Staff's failure to
implement the Investor Advocate's agenda of recommended action. This is
the same obligation that is imposed upon the Commission in the face of
any Inspector General ruling or criticism of the Agency or its Staff.
The creation of this Office threatens to disrupt, rather than
facilitate, the SEC's investigative, enforcement and rulemaking
functions.
The ostensible purpose of creating the Office of Investor Advocate
is to ensure that the interests of retail investors are built into
rulemaking proposals from the outset and that agency priorities reflect
the issues confronting investors. But, in order to achieve that
objective, it was not necessary to create an entire new bureaucracy in
order to achieve that end, nor was it necessary to give the Investor
Advocate the effective ability to second-guess every judgment made by
the Commission and its Staff as to how best to set priorities, balance
competing interests and allocate scarce resources. The Office of
Investor Advocate, far from being a resource to the Commission and its
Staff in fulfilling the Agency's mission to protect investors, will be
unnecessarily divisive.
Conclusion
The purposes behind D-F were surely laudable. But, in the critical
area of investor protection, the provisions of the Act leave a great
deal to be desired, and ultimately threaten to have adverse
consequences on investor protection. It is possible to cure these
problems, but that will require a determination by Congress, and
resolve by the Agency, to implement that regulation which will indeed
be likely to promote the needs of all investors.
I will be happy to respond to any questions the Members of the
Committee may have.
______
PREPARED STATEMENT OF BARBARA ROPER
Director of Investor Protection for the Consumer Federation of America
July 12, 2011
Chairman Johnson, Ranking Member Shelby and Members of the
Committee:
My name is Barbara Roper, and I am Director of Investor Protection
for the Consumer Federation of America (CFA), where I have been
employed since 1986. CFA is a non-profit association of approximately
300 national, State and local pro-consumer organizations founded in
1968 to advance the consumer interest through research, advocacy, and
education. I appreciate the invitation to appear before you today to
discuss enhanced investor protection after the financial crisis.
Introduction
Improving protections for average investors has been a CFA priority
for roughly a quarter century. During that time, experience has taught
us that it often takes a crisis, or at least a scandal of major
proportions, to highlight the need and provide the momentum for
investor protection reforms. The recent financial crisis was traumatic
event for U.S. investors that revealed serious shortcomings in the
regulation of certain securities markets and market players. In
particular, regulatory failures with regard to the market for asset-
backed securities (ABS) and the credit ratings on which their sales
depend were contributing causes of the crisis. Those regulatory
shortcomings resulted in serious harm even to investors with no direct
investments in ABS and no direct reliance on credit ratings. Indeed,
many individuals with no investments at all nonetheless suffered
devastating consequences in the form of lost jobs and lost homes.
The crisis and events that occurred in conjunction with the
crisis--such as the exposure of the Madoff Ponzi scheme--also revealed
more general short-comings in the quality of regulatory oversight
provided by the Securities and Exchange Commission (SEC). In some
cases, those regulatory shortcomings can be attributed to lack of
needed enforcement tools or authority. In others, inadequate resources
appear to be the cause. But recent events have also revealed regulatory
stumbles at the SEC that cannot be blamed on either of these causes but
must instead be acknowledged as operational failures of the agency
staff or a failure of will to regulate on the part of its leaders.
Since Congress began consideration of financial regulatory reform
legislation, a great deal of attention has been given to reforms
designed to improve our ability to identify and address systemic
threats, bring long-overdue regulatory oversight to the over-the-
counter derivatives markets, and even to improve consumer financial
protections by creating a new independent agency devoted to this task.
Among the lesser known achievements of the Dodd-Frank Act is its
creation of a framework that, if properly and effectively implemented,
could significantly improve investor protections. Dodd-Frank takes a
multi-faceted approach to bringing about this improvement in investor
protections. Responding to abuses directly related to the crisis, it
includes sweeping proposals to address flaws in both the asset-backed
securitization process and in credit ratings, flaws that created
incentives to write risky mortgages and helped mask those risks from
investors. In addition:
Dodd-Frank includes a suite of provisions designed to
improve the quality of regulatory oversight provided by the
SEC.
These include enhanced regulatory and enforcement tools and the
potential for increased resources to enable the SEC to carry out its
investor protection mission more effectively. Responding to recent
problems in the operations of the SEC, the Dodd-Frank Act also includes
provisions to improve outside oversight of the agency. And recognizing
that investor voices are too often drowned out by industry in debates
over agency policy, it includes mechanisms to increase investor input
in the policymaking process.
Dodd-Frank includes another set of provisions designed to
strengthen specific protections for average retail investors.
Among these, the provision to raise the standard of conduct that
applies to brokers when they give investment advice has received the
most attention, both during the legislative debate and since. However,
Title IX of Dodd-Frank also includes a number of other important
investor protections, including provisions to strengthen the ability of
defrauded investors to recover their losses, authority to address
severe conflicts of interest in industry compensation practices, and
provisions with the potential to dramatically improve the quality of
disclosures investor receive regarding both investment products and
services and the investment professionals who provide those services.
While Dodd-Frank creates a broad framework to improve investor
protections, investors will only reap the benefits if the SEC uses its
new tools and new authority effectively and if Congress provides it
with the resources necessary to enable it to do so. It is too soon to
tell whether that is likely to occur. To date, the SEC has
appropriately focused its implementation efforts on those aspects of
Dodd-Frank where it is required to act, leaving for another day areas
where it has been given new authority but no such mandate. Many of the
provisions in the Investor Protection Title fit in the latter category.
Moreover, the agency's funding status is far from clear. While the
Senate secured a welcome funding increase for the agency in 2011, the
House has been reluctant to provide 2012 funding for the agency that is
commensurate with its broadly expanded authority. Not only does this
put at risk the high profile Dodd-Frank provisions related to
derivatives, hedge funds, securitization, and credit ratings, but, if
the agency is forced to rob Peter to pay Paul, the lower profile
investor protection issues would also suffer. If that happens, average
retail investors will not only fail to reap the strengthened investor
protections promised by Dodd-Frank, they will see those basic
protections diminished and will inevitably suffer the consequences.
The investor protection provisions of Dodd-Frank are too numerous
to discuss each in detail here. Instead, my testimony will provide a
broad overview of significant reforms and highlight a few areas of
particular importance. My primary focus will be on topics of particular
relevance to retail investors. Some issues with implications for retail
investors, including municipal securities and whistleblower reforms,
are not included in this testimony, not because they are not important,
but because we lack the relevant expertise to provide informed
commentary regarding the legislative provisions on these topics.
Similarly, this testimony does not cover Dodd-Frank provisions to
improve corporate governance. Although CFA strongly supported those
reforms, others on the panel are better equipped to discuss their
particulars. On the other hand, two other issues that aren't primarily
retail investor issues--securitization reforms and credit rating agency
reforms--are discussed briefly here because they so clearly illustrate
the harm that can come to retail investors when institutional markets
are not regulated effectively.
I. Improving the Quality of Regulatory Oversight
Dodd-Frank includes a suite of provisions intended to improve the
overall quality of regulatory oversight provided by the SEC. These
include general provisions to enhance the tools available to the agency
to enforce the securities laws, provide better independent oversight of
the agency, increase investor input into the agency's policymaking
process, and authorize an increase in its funding. They also include a
provision designed specifically to strengthen regulatory oversight of
investment advisers, an area that has long been lacking. These
provisions should help to improve the quality of regulatory oversight
across the broad range of the SEC's responsibilities. The following
section describes some of those provisions in greater detail.
A. Enhancing the SEC's Enforcement Tools (various sections from 925
through 929Z)
Title IX of the Dodd-Frank Act provides the SEC with a whole host
of fairly technical but important enhancements to its enforcement
tools. These include provisions that: give the SEC broader authority to
bar bad actors from the industry (Section 925, collateral bars); ensure
that the SEC has the ability to exercise its anti-fraud authority with
regard to conduct that occurs overseas but significantly affects U.S.
investors or conduct that occurs in the United States but involves
transactions executed elsewhere (Section 929P, extraterritorial
jurisdiction); enable the PCAOB to share information with foreign
jurisdictions (Section 292J); clarify that the SEC's authority to act
against those who aid and abet securities violations is satisfied by a
showing of recklessness (Sections 929M-O); and allow for the ability to
hire specialist personnel outside the usual hiring system (Section
929G). These are sensible reforms that should strengthen the SEC's
ability to provide effective enforcement of the securities laws.
Several of them deserve extra mention.
Expert Staff: The SEC's failure to uncover the Madoff fraud has
been blamed in part on its lack of staff with the sophisticated
financial knowledge needed to understand the mechanism of the fraud.
The need to enhance the technical expertise of the staff, already
great, takes on added urgency as the agency assumes responsibility for
oversight of securities-based swaps, credit rating agencies, and hedge
funds and private equity funds--all highly complex and technical areas
that will demand staff with specialized expertise to enforce them
effectively. Giving the agency the ability to hire specialist personnel
outside the usual hiring system should assist the agency in building
the technical expertise necessary to fulfill these functions and
provide more effective regulatory oversight of an increasingly complex
market.
Extraterritoriality: The Supreme Court decision in Morrison v.
National Australia Bank left a gaping hole in SEC enforcement authority
with its ruling that Section 10(b) of the Securities Exchange Act
applies only to ``transactions in securities listed on domestic
exchanges, and domestic transactions in other securities.'' Had this
decision gone unaddressed, the SEC's ability to protect investors in an
increasingly international marketplace would have been severely
compromised. Moreover, the ability to evade U.S. fraud claims simply by
moving transactions off-shore would have created a strong incentive for
companies to avoid a U.S. listing and to execute transactions on
foreign exchanges.
Unfortunately, Dodd-Frank did not provide the same fix for private
actions under Section 10(b) and Rule 10b-5, deferring a decision until
after an SEC study of the issue. That study is currently underway. We
are hopeful that the SEC will recommend that Congress amend the
Exchange Act to ensure that Section 10(b), and the rules thereunder,
are applicable to all purchases and sales of securities by U.S.
financial institutions and individual investors residing in the United
States. This is an important addition to the authority already provided
to the SEC in the Act, first because private actions serve as an
important supplement to SEC actions, particularly in light of limited
agency resources, and second because there will still be an incentive
for companies to avoid a U.S. listing and execute transactions overseas
until the protections of U.S. law are fully restored for U.S.
investors.
PCAOB Sharing of Information with Foreign Authorities: Limits on
the PCAOB's ability to share information with foreign regulators have
been cited by some foreign jurisdictions as a reason not to permit
PCAOB to inspect auditors within their jurisdiction. But the Sarbanes-
Oxley Act requires PCAOB to inspect all auditors, including foreign
auditors that play a significant role in the audits of U.S. listed
companies. The PCAOB has sought to satisfy this requirement by
developing a program of joint audits with foreign jurisdictions, with
mixed results. While it is not likely to immediately remove all
impediments, the provision in Dodd-Frank permitting this sharing of
information should help open the way to greater cooperation in
inspections of foreign auditors. Given the important role that foreign
audit firms play in the audits of large multi-national companies as
well as foreign companies listed in the United States, ensuring that
these auditors comply with U.S. audit standards is an important
investor protection priority. We are encouraged that the new leadership
at the PCAOB has made this a priority and appears to be working
effectively to make progress in this area.
B. Strengthening Oversight of the SEC (Subtitle F)
Dodd-Frank also includes a package of reforms designed to improve
outside oversight of the SEC. It achieves this primarily through a
series of Government Accountability Office (GAO) reviews and reports to
Congress. These include an annual financial controls audit of the
agency, a triennial report by GAO on the quality of the agency's
personnel management, triennial GAO reports on the SEC's oversight of
SROs, and a GAO study of the revolving door between the SEC and the
securities industry it regulates. Perhaps most significantly, Section
961 of Dodd-Frank requires the SEC to report to Congress each year on
its examinations of regulated entities and, in doing so, to certify the
adequacy of its supervisory controls to carry out these exam functions.
Effective exams are central to the agency's ability to detect and deter
wrong-doing. This annual reporting requirement, subject to GAO and
congressional review, should help to quickly identify any weaknesses in
the exam program and focus agency attention on improving the quality of
these examinations. That has the potential to significantly enhance
investor protection.
An organizational study of the agency required by Dodd-Frank has
already been completed.\1\ The purpose of the study was to examine the
internal operations, structure, and the need for reform at the SEC. In
addition to praising recent initiatives undertaken by the agency to
improve its efficiency and effectiveness,\2\ the report suggests
additional steps for the agency to take to improve efficiency. Among
its more substantive recommendations are for the agency to play a more
active role in overseeing the self-regulatory organizations (SROs)
under its jurisdiction, to upgrade its information technology, and to
hire staff with risk management and other high-priority skills.
Ultimately, however, the report concludes that agency is unlikely to be
able to fulfill even its high priority functions without additional
resources. We share that conclusion, as we discuss in greater detail
below.
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\1\ ``U.S. Securities and Exchange Commission Organizational Study
and Reform,'' Boston Consulting Group, March 10, 2011.
\2\ These include reorganization of the Division of Enforcement and
the Office of Compliance Inspections and Examinations, the rollout of
the new Tips, Complaints and Referrals program, and hiring of a Chief
Operating Office and a new Chief Information Officer.
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C. Providing Investors with Greater Input into Agency Policy Decisions
(Sections 911 and 915)
The SEC decides issues of enormous import to investors every day,
often with little or no input from the investors affected by those
decisions. This does not reflect any intent to shut investors out of
the process. Rather, it reflects the simple fact that investors often
lack the organization, manpower and resources to monitor agency actions
and interact effectively with SEC leaders and staff as they set the
agency's agenda and develop specific proposals to achieve that agenda.
In contrast, industry is well funded and organized to perform this
function, giving market participants an advantage in communicating with
the agency that is further magnified by the revolving door that exists
between the SEC and the securities industry. The inevitable result is
that industry concerns tend to dominate the policy debate, while
investor concerns can too easily be drowned out.
The Dodd-Frank Act includes two provisions specifically designed to
increase investor input into the agency's policymaking process and
ensure that investor concerns are heard. Section 915 creates a new
Office of Investor Advocate within the agency, while Section 911
establishes a permanent Investor Advisory Committee. Properly
implemented, these provisions have the potential to make the agency
more aware of and thus more responsive to investor concerns and
priorities. The result should be an agency that more effectively
fulfills its mission to protect investors and promote the integrity of
the capital markets.
The Office of Investor Advocate: The legislation seeks to ensure
that this office will truly and effectively serve the interests of
investors by requiring that the Investor Advocate be an individual with
a background representing the interests of investors, by providing the
office of the Investor Advocate with appropriate staffing and with
unimpeded access to agency and SRO documents, by ensuring that the
Investor Advocate reports directly to the Chairman, and by requiring
that the Commission respond promptly to recommendations of the Investor
Advocate.
Moreover, several important functions are entrusted to this office,
including:
Identifying areas in which investors would benefit from
changes in the regulations of the Commission or industry self-
regulatory organizations (SROs);
Identifying problems investors have with financial service
providers and investment products;
Analyzing the potential impact on investors of proposed
Commission and SRO rules and regulations; and
Assisting retail investors in resolving problems with the
SEC and SROs.
If the Commission follows through by appointing an energetic,
effective and knowledgeable individual to this position and staffing
the office appropriately, investors should benefit from an agency that
is more attuned and responsive to their concerns.
This provision also has the potential to improve the quality of
congressional oversight of the SEC. That is because Dodd-Frank requires
the Investor Advocate to report directly to Congress without prior
review or approval by the Commission or its staff. This should enhance
Congress's ability to assess the effectiveness of the agency in serving
the needs of investors, particularly in administrations that are less
attuned to those concerns.
So far, however, this provision of the legislation has not been
implemented. Implementation was delayed first by the hold-up in
finalizing a 2011 budget. Now that the SEC's 2011 budget has been set,
we understand that the Commission is awaiting approval by the House and
Senate appropriations committees of its plan to reprogram funds for
this purpose. We hope that any questions about this reprogramming plan
can be resolved without difficulty so that this potentially powerful
ally for investors can be put into place. The need for this investor
input is particularly pressing given the importance of the issues
currently being decided by the agency and the intensity of industry
lobbying to weaken or water down many of those proposals.
The Investor Advisory Committee: When SEC Chairman Mary Schapiro
took office, she made it an early priority to establish an Investor
Advisory Committee to provide input on investor priorities to the
Commission and its staff. Recognizing the potential benefits of this
committee, the Dodd-Frank Act formalizes its existence as a permanent
advisory committee to the Commission. As with the Office of Investor
Advocate, however, implementation of this provision is awaiting
approval of the Commission's funding reprogramming plan by
congressional appropriators. Meanwhile, the existing committee has been
disbanded in order to allow for changes in its make-up required by
Dodd-Frank. Because this committee has the potential to enhance the
agency's understanding of and responsiveness to investor protection
concerns, we urge a speedy resolution to any remaining impediments to
its implementation.
D. Increasing SEC Funding (Subtitle J)
Over the course of the past three decades, U.S. securities markets
have exploded in size, complexity, international reach, and
technological sophistication, all the while becoming the primary means
by which Americans fund their retirement. Meanwhile, with the exception
of a one-time major funding boost after the Enron and WorldCom
accounting scandals, the staffing level of the SEC has grown slowly if
at all. To be specific, staffing at the agency has grown roughly 85
percent from 2,050 FTEs in 1980 to 3,800 FTEs today, but the workload
of the agency has grown many times faster. For example, based on my
rough calculations, since 1980:
the number of investment adviser firms overseen by the
agency has grown by more than 150 percent, and the assets
managed by these professionals has grown by roughly 7,400
percent;
the number of mutual funds overseen by the agency has grown
more than 430 percent; and
while the number of broker-dealer firms has decreased by 20
percent, the number of registered representatives they employ
and the number of branch offices from which they operate has
skyrocketed, by roughly 225 percent and 2,100 percent
respectively.\3\
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\3\ These calculations are based in large part on numbers from a
``Self-Funding Study,'' prepared by the Office of the Executive
Director of the U.S. Securities and Exchange Commission and submitted
in partial response to the request of the Securities Subcommittee of
the Senate Committee on Banking, Housing and Urban Affairs S. Rpt. 100-
105), December 20, 1988 as well as on more recent speeches by and
testimony of SEC Chairman Mary Schapiro.
The result is that the SEC today is critically under-staffed to
carry out its existing responsibilities, let alone take on the vast new
responsibilities entrusted to the agency in Dodd-Frank. And that
doesn't take into account the woeful state of the agency's technology.
In Dodd-Frank, Congress recognized the need for increased SEC
resources by authorizing funding increases that would roughly double
the agency budget by 2015. Specifically, the bill authorizes funding of
$1.3 billion in 2011, $1.5 billion in 2012, $1.75 billion in 2013, $2
billion in 2014, and $2.25 billion in 2015. We strongly support fully
funding the agency at these levels as an essential component of any
effort to increase investor protections, and we greatly appreciate the
leadership that Chairman Johnson and Members of this Committee have
shown in fighting for increased funding. Unfortunately, the debates
over the FY 2011 and 2012 budget have already made clear that turning
those authorizations into appropriations is going to be a tough fight.
Some in Congress continue to resist these funding hikes, even though
the agency's budget is fully offset by user fees and, since fees have
to be adjusted to match the appropriation, there is no deficit
reduction benefit from reduced funding. Indeed, even if the agency were
fully funded at the authorized level for 2012, user fees would be
reduced, since they currently bring in well over the authorized amount.
While we are sympathetic to those who argue that money alone cannot
solve all of the agency's problems, we also believe that, without
additional funding, the agency cannot reasonably be expected to
effectively fulfill its investor protection mission. We urge Members of
this Committee to continue to fight for full funding, and we offer our
full support for those efforts.
E. Improving the Quality of Investment Adviser Oversight (Section 914)
One area where the funding shortfall is particularly critical is in
the regulatory oversight of investment advisers. This issue received
heightened attention as a result of the unraveling of the Madoff Ponzi
scheme. This is ironic, since Madoff was a broker-dealer regulated
exclusively as a broker-dealer up until just 2 years before his fraud
was uncovered. If the Madoff scandal was an indictment of anything,
therefore, it was an indictment of the effectiveness of broker-dealer
oversight.\4\ That said, the problem of inadequate investment adviser
oversight is quite real. And it is first and foremost a resource
problem, a problem that began to emerge in the late 1980s at a time
when both mutual funds and investment advisers were growing at an
extremely rapid pace and agency staffing to oversee these areas was
growing slowly if at all. By the early 1990s, the problem had reached
crisis proportions, with inspections so infrequent that a small adviser
might reasonably expect to set up shop and reach retirement without
ever seeing an SEC inspector.\5\
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\4\A group of independent FINRA board members, led by Charles
Bowsher, has since conducted a very credible examination of FINRA's
failure to uncover both the Madoff and the Stanford frauds, and FINRA
has reportedly begun to implement the recommendations of that study to
improve the quality of its broker-dealer oversight.
\5\ At the time, SEC staff members estimated that it small advisers
were on a once every 40 years inspection cycle.
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Over the years, CFA has supported a variety of approaches to solve
this resource problem, including increased appropriations to the SEC,
self-funding for the agency to free it from the appropriations process,
and user fees on investment advisers to pay for increased oversight.
None has been adopted. While the resource problem ultimately rests with
Congress to resolve, Section 914 of the Dodd-Frank Act required the SEC
to conduct a study assessing the need for additional resources for
investment adviser examinations and options available to Congress to
address this issue, including by delegating this responsibility to a
self-regulatory organization (SRO).
Earlier this year, the SEC issued its Section 914 study.\6\ In it,
the staff documented a decline in the number and frequency of
inspections of registered investment advisers over the past 6 years and
described new challenges the Commission will face as it takes on
responsibility for registration and oversight of private fund advisers.
We share the study's conclusion that, ``The Commission's examination
program requires a source of funding that is adequate to permit the
Commission to meet the new challenges it faces and sufficiently stable
to prevent adviser examination resources from periodically being
outstripped by growth in the number of registered investment
advisers.''
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\6\ ``Study on Enhancing Investment Adviser Examinations,'' by the
staff of the Division of Investment Management of the Securities and
Exchange Commission, January 2011. The study is available here:
www.sec.gov/news/studies/2011/914studyfinal.pdf.
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The study outlines three options for Congress to consider adopting
to address this ``capacity constraint:''
imposing user fees on SEC-registered investment advisers to
fund their examinations by SEC inspection staff;
authorizing one or more SROs to examine, subject to SEC
oversight, all SEC-registered investment advisers; or
authorizing FINRA to examine dual registrants for
compliance with the Advisers Act.
In the past, CFA has categorically opposed delegating investment
adviser oversight to an SRO, particularly one dominated by broker-
dealer interests and particularly if that SRO were given rulemaking
authority. We continue to believe the user-fee approach outlined in the
SEC report offers the best option for funding enhanced inspections in a
way that promotes investor protection while minimizing added costs to
industry.
However, having spent the better part of two decades arguing for
various approaches to increase SEC resources for investment adviser
oversight with nothing to show for our efforts, we have been forced to
reassess our opposition to the SRO approach. Specifically, we have
concluded that a properly structured SRO proposal would be a
significant improvement over the status quo. Too often, however, the
SRO approach is presented as an easy solution by individuals who have
not adequately confronted the many thorny issues it presents. The SEC
study does an excellent job, in our view, of laying out the issues that
would need to be addressed if Congress were to pursue this approach.
Only by answering the following questions can Congress develop an SRO
proposal that adequately protects investor interests while avoiding
imposing undue costs on small advisers.
How should such an approach be structured in light of the
diversity in the investment adviser community?
How can the risks of industry capture be avoided?
What are the implications of strong industry opposition to
such an approach?
What would the costs of effective SRO oversight be, and how
would they be borne by the many small investment adviser firms?
What resources would the SEC need in order to provide
effective oversight of any such SRO or SROs to which this
responsibility might be delegated?
Should an SRO be an inspection-only SRO, or should it also
have broader rulemaking authority?
What entity (or entities) is best suited to this task?
Ultimately, whatever approach Congress chooses to take, we share
the view expressed by SEC Commissioner Elisse Walter in her statement
on the study, ``that the current resource problem is severe, that the
problem will only be worse in the future, and that a solution is needed
now.'' We urge you to act to resolve this problem sooner rather than
later.
F. Improving Regulation of Financial Planners (Section 919C)
Section 919C of Dodd-Frank required a GAO study of the adequacy of
financial planning regulation. Deferring to a study was a reasonable
approach for Congress to take, since the crowded legislative calendar
in the midst of the crisis did not allow for an adequate review of the
issues or of various proposals that have been put forward to improve
financial planning regulation. Unfortunately, the GAO study on
financial planning regulation,\7\ which was released in January,
represents a real missed opportunity. While it correctly highlights
problems with the weak conduct standards that apply to insurance
agents, it fails to address the basic question of how best to regulate
activity that cuts across a variety of regulatory domains.\8\ This is
an important question that deserves more thoughtful analysis than it
received in the GAO study. Indeed, we would encourage this Committee to
look into the issue once the press of overseeing implementation of
Dodd-Frank has passed.
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\7\ ``Consumer Finance: Regulatory Coverage Generally Exists for
Financial Planners, but Consumer Protection Issues Remain,'' Government
Accountability Office, January 2011. The report is available here:
http://www.gao.gov/new.items/d11235.pdf.
\8\ The problems with the GAO study are summed up well in a
Morningstar article by University of Mississippi Law Professor Mercer
Bullard, ``The Future of Financial Planning Regulation.'' The article
is available here: http://news.morningstar.com/articlenet/
article.aspx?id=386262
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II. Strengthening Protections for Retail Investors
As the financial reform legislation worked its way through
Congress, it became a vehicle for several specific measures to improve
investor protections. These are not for the most part directly related
to the causes of the crisis (though some are directly related to the
Madoff scandal). Instead, they address long-standing weaknesses in
protections for retail investors. The issues covered by these
provisions range from the protections that apply to investors'
interactions with those they rely on for investment advice, the quality
of disclosures investors receive regarding investment products and
services, and the ability of defrauded investors to recover their
losses. For the most part, these Title IX provisions authorize rather
than require the SEC to act. With the agency so far occupied primarily
with Dodd-Frank mandates, and appropriately so, progress to date has
been minimal. Once the agency has an opportunity to turn its attention
to these issues, however, these provisions have the potential to
dramatically improve protections for retail investors in areas long
identified as high priorities by investor advocates.
A. Raising the Standard for Brokers' Investment Advice (Section 913)
Improving the protections that apply to investors' interactions
with the financial intermediaries they rely on for investment advice
and recommendations has long been a priority for CFA and other investor
advocates. There are several reasons for this. Research suggests that
investors are ill-equipped to make an informed choice among investment
professionals, since they typically cannot distinguish between brokers
and investment advisers, do not realize that their recommendations are
subject to different legal standards, and do not understand the
difference between those standards. Moreover, additional research has
found that investors rely heavily, if not exclusively, on the
recommendations they receive from investment professionals, typically
doing little if any additional research on the investments recommended.
This makes them extremely vulnerable to investment professionals who
take advantage of that trust. That is why ensuring that these
investment professionals act in their customers' best interests--both
by raising the standard of conduct that applies to broker dealers when
they give investment advice and by improving the quality of regulatory
oversight for investment advisers--is such a high investor protection
priority.
Section 913 of Dodd-Frank advances this goal by authorizing the
Securities and Exchange Commission to impose a fiduciary duty on
brokers when they give personalized investment advice to retail
investors. In January, the Commission released the study required by
the Act as a predicate to any regulatory action in this area.\9\ In it,
the Commission proposes to impose a uniform fiduciary duty on brokers
and advisers through dual rules under the Securities Exchange Act and
the Investment Advisers Act. This approach, which preserves the broker-
dealer business model while raising the standard that applies to broker
recommendations, has won enthusiastic praise not only from traditional
proponents of a fiduciary duty, such as CFA, but also from the leading
broker-dealer trade associations.\10\
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\9\ ``Study on Investment Advisers and Broker-Dealers,'' by the
staff of the U.S. Securities and Exchange Commission, January 2011. The
report is available here: http://www.sec.gov/news/studies/2011/
913studyfinal.pdf.
\10\ Unfortunately, a relatively small but vocal segment of the
broker-dealer community, in particular those whose business model is
dependent on the sale of high-cost variable annuities, has continued to
oppose any Commission action to raise the standard of conduct for
brokers. In voicing their opposition, they rely on arguments that are
at best misinformed, at worst are outright deceptive, that requiring
brokers to act in their customers' best interests would somehow harm
middle income and rural investors. Contrary to the claims of these
critics, the proposal put forward by the SEC offers middle income
investors the best of both worlds, preserving their access to
commission- and transaction-based services while simultaneously helping
to ensure that those services are delivered with the investor's best
interests in mind.
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The fact that the SEC has identified an approach to this issue that
has won such broad support offers an opportunity for long-overdue
progress on this key investor protection priority. SEC Chairman Mary
Schapiro has indicated that the Commission is likely to move forward on
rulemaking later this year. CFA strongly supports the Commission on
this and urges Members of this Committee to do so as well.
B. Improving Disclosures (Sections 912, 917, 919, 919B)
In a number of areas and to a large extent, our system of investor
protection is predicated on the notion that investors who are armed
with complete and accurate information will be able to look out for
their own interests. This concept, which predates the democratization
of securities markets that has occurred over the past several decades,
may be overly optimistic in its assumptions about the financial
sophistication of average retail investors. At the very least, it puts
a premium on our ability to deliver the information investors need, in
a form they can access and understand, at a time when it is useful to
them in making their investment decisions. I suspect that, if the SEC
were to make extensive use of the disclosure testing authority provided
to the agency in Dodd-Frank, it would find that few if any of the
disclosures currently provided to investors satisfy this three-part
test for effectiveness. In short, much can and should be done to
improve the content, format and timing of disclosures, and the Dodd-
Frank Act provides the SEC with a sound framework for making those
improvements.
Section 917, for example, requires the SEC, as part of its study of
financial literacy, to look at a variety of issues that are central to
developing effective disclosures. These include identification of the
key information investors need to make sound investment decisions as
well as ways to improve the timing, content and format of disclosures.
By requiring this analysis in the context of a study of financial
literacy, this provision highlights the need to design disclosures with
a realistic understanding of the financial sophistication of investors
in mind. Section 912 builds on this study by authorizing the agency to
engage in investor testing of disclosures. This authority can be used
both to learn what methods and formats of disclosure generally are most
effective in conveying information to investors and to test specific
disclosure documents for clarity and effectiveness. It can and should
be used both to help in the development of new disclosures and to
improve existing disclosures. It is our understanding that the agency
has begun to make at least limited use of this new authority, and we
hope that is a trend that will continue and grow. For that to happen,
however, the SEC must receive adequate funding for this purpose.
Timing of disclosures can determine whether or not they play a
significant role in conveying important information to investors.
Information received after the sale is of little if any use, but that
is the current norm in all too many situations. Even information
delivered at the point of sale may be of little value, if the
investment decision has already been reached. To really benefit,
investors must receive the key information when they are still
evaluating their investment options. That argues for delivery at the
point of recommendation, a goal that may be more easily achieved as we
move toward greater use of the Internet to satisfy disclosure
requirements. Section 919 of Dodd-Frank provides the SEC with tools to
achieve this goal of timelier disclosures, by authorizing the agency to
require pre-sale disclosures with regard to both investment products
and services. We especially appreciate the decision to expand this
provision beyond just mutual funds to include all investment products
and services. This will give the agency the ability to take what it
learns from its study on financial literacy and from any disclosure
testing it conducts and use it to develop disclosure documents that are
much more useful to retail investors.
C. Strengthening Protections for Defrauded Investors (Sections 921,
929B, 929H, 929Y, 929Z)
Title IX of Dodd-Frank also includes several provisions that could
be used to improve, or at least protect, the ability of defrauded
investors to recover their losses. These include provisions in Section
929B to expand the Fair Fund to include civil penalties, the Section
929Y study of extraterritoriality and private rights of action, and the
Section 929Z study of private rights of action against those who aid
and abet securities fraud. For investors to benefit from the latter two
provisions, however, Congress will need to follow up on these studies
and amend the Securities Exchange Act to provide U.S. investors with
the ability to pursue private actions under Section 10(b) for foreign
transactions and against those who aid and abet securities fraud. A
series of recent court decisions have significantly limited defrauded
investors' right to recovery. We urge Congress to redress that
imbalance by restoring basic private rights of action in these areas.
Perhaps more significantly, Section 921 of Dodd-Frank authorizes
the SEC to limit or restrict the use of forced arbitration clauses in
brokerage contracts. CFA is a strong support of alternative dispute
mechanisms. We believe it is absolutely essential the investors retain
access to an arbitration system that is fair, efficient and affordable.
It is precisely for this reason that we oppose pre-dispute binding
arbitration clauses. Certain cases simply are not suited for resolution
through arbitration, particularly complex fraud cases that require
extensive discovery proceedings and a sophisticated reading of the
applicable law. When forced into arbitration by pre-dispute binding
arbitration clauses, these cases can both clog the arbitration system
and increase its costs. Those operating the arbitration forum, in this
case FINRA, come under pressure to adopt more formal, court-like
proceedings to ensure that such cases can be dealt with fairly. And the
goals of a fast, efficient, affordable system to resolve disputes end
up being undermined. CFA therefore supports a careful approach to
limiting the use of binding arbitration clauses that preserves investor
access to arbitration but doesn't force cases into arbitration that
don't belong there. So far, however, the SEC does not appear to have
taken up this issue.
D. Strengthening Protections Regarding Custody of Client Assets
(Section 411)
Responding at least in part to concerns raised by the Madoff
scandal, Section 411 of the Dodd-Frank Act requires investment advisers
to have appropriate protections in place to safeguard client assets
held in custody, including by requiring an independent auditor to
verify the assets. While we believe this is a useful requirement, it is
worth noting that Madoff was a broker, not an investment adviser, for
the bulk of the period covered by the scandal. Any Madoff-related
reforms to address weaknesses in custody requirements would more
appropriately focus on strengthening protections with regard to brokers
who self-custody.
E. Adjusting the Definition of Accredited Investor (Section 413)
Several definitions in our securities laws seek to draw a line
between sophisticated investors capable of looking out for their own
interests and others who require the protection of the securities laws.
One such is the accredited investor definition. While we question the
validity of any definition based primarily on net worth or income, the
validity of the definition is particularly questionable when it is not
regularly adjusted to keep pace with inflation. Such has been the case
with the accredited investor definition. Section 413 of Dodd-Frank
significantly improves the definition by adjusting the net worth
trigger upward, excluding the value of the primary residence from that
calculation, and providing for periodic reviews and adjustments of the
standard.
III. Addressing Securities Regulation Failures Related to the Crisis
While they fall somewhat outside the range of topics typically
thought of as retail investor protection issues, two investor
protection issues directly related to the financial crisis deserve at
least a mention here--securitization reform and strengthened regulation
of credit rating agencies. These issues perfectly illustrate how a
failure to regulate effectively in largely institutional markets can
have devastating consequences for retail investors.
A. Reforming the Asset-Backed Securitization Process
As the crisis unfolded, much attention was given to the way
securitization had fundamentally changed incentives in the mortgage
markets, making lenders far less concerned about ensuring the
borrower's ability to repay. One reason this occurred was that the
mortgage-backed securities (MBS) and collateralized debt obligations
(CDOs) based on those securities were both incredibly complex and
almost completely opaque, leaving investors in the securities with
little or no information about the quality of underlying loans. As Penn
State Visiting Law Professor Richard E. Mendales put it, ``The many
layers between debt instruments providing the underlying cash-flow for
such instruments and the final instruments sold on world markets
destroyed the transparency that the securities laws are designed to
create . . . ''\11\
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\11\ Mendales, Richard E., ``Collateralized Explosive Devices: Why
Securities Regulation Failed to Prevent the CDO Meltdown, and How to
Fix It,'' University of Illinois Law Review.
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The diligent investor who attempted to conduct due diligence on
these securities got no assistance from securities regulations, which
allowed the sale of MBS with minimal disclosures through the SEC's
shelf-registration process. As a result, even those MBS that were
registered with the SEC could be sold based ``not upon a detailed
prospectus but rather on a basic term sheet with limited
information.''\12\ Regulation A/B also eliminated underwriters'
obligation to perform due diligence to confirm adequate loan
documentation. Bad as disclosures were for more traditional MBS, they
were often even worse for CDOs, which were typically sold in private,
144A sales to Qualified Institutional Buyers (QIBs) with even less
information on underlying assets.
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\12\ Investors Working Group, U.S. Financial Regulatory Reform: The
Investors' Perspective, July 2009. (The Investors Working Group is an
Independent Taskforce Sponsored by CFA Institute Centre for Financial
Market Integrity and Council of Institutional Investors.) [Hereinafter,
The Investors' Perspective]
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Subtitle D of Title IX includes a broad set of provisions to reform
the asset-backed securitization process. The legislation attempts to
address the securitization's deleterious effect on incentives to ensure
borrowers' ability to repay by requiring securitizers to have some
``skin in the game'' with regard to the asset-backed securities they
issue. Just as important, Section 942 of Dodd-Frank requires more
extensive disclosures of information necessary to permit investors to
conduct a reasonable due diligence review of the securities. Section
945 requires issuers of asset-backed securities to perform a review of
the assets underlying the security and to disclose the nature of that
review to investors. Importantly, in issuing its rules implementing
Section 945, the SEC appropriately specified that the due-diligence
reviews must be adequate to provide reasonable assurance that the
disclosures provided to investors are accurate. Meanwhile, the broader
ABS disclosure rules required by the Act have been proposed but not yet
adopted. When they are fully implemented, these provisions should go a
long way toward making it possible for the institutional investors who
participate in this market to make better informed investment
decisions, and that should benefit retail investors by reducing risks
in the financial system.
B. Strengthening Regulation of Credit Rating Agencies
One justification given for allowing sale of MBS and CDOs without
adequate disclosures was that they were highly rated by the credit
rating agencies. In fact, the entire system of regulation for the
securitization process was built on the assumption that ratings could
reliably assess the risks associated with these investments. Special
Purpose Vehicles set up to issue the securities were exempt from
regulation under the Investment Company Act by virtue of their
investment grade ratings. Eligibility for sale through the shelf
registration system was also based on ratings, as was favorable
treatment under financial institution capital standards. Mendales
summed up our regulatory reliance on ratings this way: ``Unregulated
ratings for asset-backed securities became proxies for the full
disclosure required by securities law. Thus, when they were repackaged
into more complex CDOs or used indirectly to create derivative
obligations such as default swaps, participants in transactions and
institutions holding the securities as part of their required
capitalization relied on the high ratings given to component asset-
backed securities rather than looking at the assets underlying
them.''\13\ As events later demonstrated, the reliance on ratings by
investors and regulators alike proved to be disastrously misguided.
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\13\ Collateralized Explosive Devices. [footnotes omitted]
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Subtitle C of the Dodd-Frank Act seeks to address this fundamental
weakness in the system through a multi-faceted approach to credit
rating agency reform. This includes: improving regulatory oversight of
credit ratings agencies, strengthening internal controls over the
rating process, making the assumptions behind the ratings more
transparent to users of those ratings, making the ratings agencies more
accountable for following sound procedures, and reducing regulatory
reliance on ratings.
Implementation of the reforms is still very much a work in
progress. Still awaiting approval by House and Senate appropriators of
its funding reprogramming plan, the SEC has not yet been able to create
the new Office of Credit Ratings required by Dodd-Frank. However, it
has reportedly begun the stepped up inspections of rating agencies
required under the Act. In addition, the SEC recently issued the rule
proposals implementing the operational reforms required by the Act.
Meanwhile, the agency has put on hold provisions designed to increase
legal accountability of ratings agencies by subjecting them to the same
expert liability that auditors and underwriters face when their ratings
are used in prospectuses. Faced with a threatened boycott by ratings
agencies and fearing a shut-down of the still struggling MBS market,
the SEC has issued a no action letter permitting asset-backed
securities to be issued without inclusion of a rating in the
prospectus. While we believe ratings agencies ought to be held legally
accountable for following reasonable ratings procedures, we understand
the rationale behind the SEC action.
The SEC has also begun the difficult task of reducing regulatory
reliance on credit ratings. CFA strongly supports the concept behind
this proposal, but we preferred the more flexible approach contained in
the original Senate bill. Had that approach prevailed, Federal
financial regulators might not be in the situation in which they now
find themselves--forced to remove regulatory references to credit
ratings without having identified any acceptable alternative measures
of creditworthiness to put in their place. We are deeply concerned that
this well-intended provision of the legislation may end up increasing
risks in the financial system. We strongly encourage this Committee to
take a closer look at how this provision is being implemented and what
the implications are for the safety and stability of the financial
system.
Conclusion
With the exception of the September 11 terrorist attacks, I can
think of no events in recent history that have been as frightening for,
or as devastating to, investors as the recent financial crisis. For
several months, the markets appeared to be in free-fall. As the Dow
plunged ever lower, hard won retirement savings accumulated over many
years were vaporized overnight. No one knew when, of where, the market
would finally reach bottom. Some who had planned to retire had to put
those plans on hold. The least fortunate lost their jobs and their
homes as the credit markets froze and the economy tanked. With
unemployment still topping 9 percent, many Americans are still feeling
those ill effects today. In short, the financial crisis has left
Americans feeling as fearful of financial disaster as the events of 9/
11 left us fearful of another terrorist attack.
A peculiar characteristic of the crisis for retail investors is
that they suffered these devastating effects despite the fact that they
had never invested in the toxic but nonetheless AAA-rated mortgage-
backed securities that were a root cause of the crisis and had probably
never even heard of the credit default swaps that helped spread that
risk throughout the global economy. Instead, retail investors suffered
the collateral damage of regulatory failures in markets to which they
had no direct exposure. The bulk of Dodd-Frank is dedicated to
rectifying those broader market failures, and appropriately so.
Although most investors are unlikely to understand the cause and
effect, reforms designed to improve the overall effectiveness of
regulation in the financial markets should benefit these investors
indirectly both by promoting the financial stability that is crucial to
their financial security, but also by making the regulators (in this
case the SEC) more effective in carrying out their basic investor
protection functions. In addition, Dodd-Frank includes a number of
provisions designed to address long-standing weaknesses in our system
of protections for unsophisticated retail investors. If these
provisions are implemented effectively, the SEC and our system of
investor protection generally could emerge stronger than before.
The investor protection framework provided in Dodd-Frank is a sound
one. But it only takes us so far. For it to succeed, regulators will
have to demonstrate a willingness to use their authority aggressively
and effectively, and Congress will have to provide them with both the
resources and the backing to enable them to do so.
______
PREPARED STATEMENT OF ANNE SIMPSON
Senior Portfolio Manager, Global Equities
California Public Employees' Retirement System
July 12, 2011
Chairman Johnson, Ranking Member Shelby, and Members of the
Committee:
Good morning. I am Anne Simpson, Senior Portfolio Manager, Global
Equities at the California Public Employees' Retirement System
(CalPERS). I am pleased to appear before you today on behalf of CalPERS
and share our views on a number of important investor protections
included in Dodd-Frank Wall Street Reform and Consumer Protection Act
(Dodd-Frank).
My testimony includes a brief overview of CalPERS, including how we
participate in corporate governance and make investment decisions. My
testimony also includes a discussion of our views on those key
provisions of the Dodd-Frank we believe significantly enhance corporate
governance and thereby contribute to the quality of risk adjusted
returns in our portfolio.
Some Background on CalPERS
CalPERS is the largest public pension fund in the United States
with approximately $232 billion in global assets and equity holdings in
over 9,000 companies worldwide. CalPERS provides retirement benefits to
more than 1.6 million public workers, retirees, their families and
beneficiaries. We payout some $15 billion in benefits a year, and 70
cents on the dollar comes from investments, a significant portion of
which in internally managed.\1\
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\1\ Approximately three-quarters of CalPERS global equities
portfolio is managed by internal investment professionals.
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Those we support are on modest incomes: typically, $2,000 in
benefits a month. For that reason, as a significant institutional
investor with a long-term investment time horizon, CalPERS has a vested
interest in maintaining the integrity and efficiency of the capital
markets. Moreover, size and long term liabilities mean we have to look
for market solutions. We cannot simply sell our shares when things go
wrong. As a result, corporate governance issues are of great concern to
us and those on whose behalf we are investing: the public servants such
as the police officers, firefighters, school employees and others who
rely on us for their retirement security.
Participation in Corporate Governance Decisions
CalPERS has been a long-time proponent of good corporate
governance, which serves to protect, preserve and grow the assets of
the fund, and we strongly support the corporate governance reforms
found in Dodd-Frank. We have also strongly supported other measures
which are vital to a coordinated and comprehensive reform effort. These
are not the focus of today's discussion, but they are critical to the
project: systemic risk oversight, proper funding and independence for
regulators, derivatives reform, credit rating agency overhauls among
them.
As a shareowner of each of the stocks held in its portfolios,
CalPERS has developed, and periodically updates, a comprehensive set of
corporate governance principles and detailed guidelines that govern the
voting of the related proxies. These principles and guidelines focus on
a broad range of issues including how we will vote on director nominees
in uncontested elections and in proxy contests.
CalPERS votes its proxies in accordance with our guidelines. Both
the CalPERS proxy policy and the actual proxy votes cast are published
on our Web site, so that all constituents and interested parties can
know our positions on these important issues. Moreover, as part of our
proxy voting diligence process, we have detailed discussions with many
companies in our portfolio. We engage underperforming companies in
extensive dialogue through our Focus List program, which was found to
produce superior returns over a 10-year period.\2\
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\2\ See The CalPERS Effect on Targeted Company Share Prices,
Wilshire Associates, (November 2010). http://www.calpers.ca.gov/eip-
docs/about/board-cal-agenda/agendas/invest/201008/item05a-2-02-01.pdf.
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Shareowner proxy voting rights are considered to be valuable assets
of the fund. Attention to corporate governance promotes responsible
business practices that serve as an integral component to a company's
long-term value creation. In instances where guidelines are not
dispositive on shareowner or management proposals, the Office of
Corporate Governance, which I oversee, reviews and makes proxy voting
recommendations that are consistent with the best interests of the fund
and our fiduciary duties.
Investment Decision Making Process
As indicated above, CalPERS takes a long-term strategic approach to
its investment decisionmaking process. Annually, a comprehensive
``Strategic Investment Plan'' is developed jointly by CalPERS'
investment staff and its external consultants, with input from and
subject to final approval of the 13-member board. The plan is based on
careful analysis of the long-term outlook for the capital markets and
major qualitative and quantitative factors including the unique needs,
preferences, objectives and constraints of CalPERS. This detailed
investment plan manifests itself in the development of an asset
allocation framework designed to achieve the ongoing commitment to
diversification and provide guidance in the investment decisionmaking
process including advancing investment strategies, the hiring and
monitoring of external investment advisors, portfolio rebalancing and
meeting cash needs.
How Inadequate Corporate Governance Contributed to the 2008 Financial
Meltdown
It is widely acknowledged that the 2008 financial crisis was
fuelled by a toxic combination of lax oversight and misaligned
incentives.\3\ Too many CEOs pursued excessively risky strategies or
investments that bankrupted their companies or weakened them
financially for years to come.\4\ Boards of directors were often
complacent, failing to challenge or rein in reckless senior executives
who threw caution to the wind.\5\ And too many boards approved
executive compensation plans that rewarded excessive risk taking.\6\
Others simply did not have robust risk management systems in place, or
had these subservient to short term revenue chasing. The Dodd-Frank
focus upon improving transparency around incentives and giving
shareowners the tools to improve oversight of boards is therefore
absolutely on target. We look forward to further improvements in
disclosure also under discussion by financial regulators, for example
to ensure that compensation below board level is disclosed for those
who can have an impact upon the company's over risk profile, and also
to improve understanding of pay equity across companies.
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\3\ See Financial Crisis Inquiry Commission, The Financial Crisis
Inquiry Report xviii (Jan. 2011), http://www.gpoaccess.gov/fcic/
fcic.pdf (``We conclude dramatic failures of corporate governance and
risk management at many systemically important financial institutions
were a key cause of this crisis'' ) [hereinafter FCIC Report];
Investors' Working Group, U.S. Financial Regulatory Reform, The
Investors' Perspective 22 (July 2009), http://www.cii.org/UserFiles/
file/resource%20center/investment%20issues/
Investors'%20Working%20Group%20Report%20(July%
202009).pdf (``The global financial crisis represents a massive failure
of oversight'') [hereinafter IWG Report].
\4\ IWG Report, supra note 1, at 22.
\5\ See Staff of S. Permanent Subcomm. on Investigations, Wall
Street and the Financial Crisis: Anatomy of a Financial Collapse 185-86
(Apr. 13, 2011), http://hsgac.senate.gov/public/_files/
Financial_Crisis/FinancialCrisisReport.pdf (providing evidence that
board oversight of Washington Mutual, Inc., including oversight of
enterprise risk management, was ``less than satisfactory''); IWG
Report, supra note 1, at 22.
\6\ FCIC Report, supra note 1, at xix (``Compensation systems-
designed in an environment of cheap money, intense competition, and
light regulation-too often rewarded the quick deal, the short-term
gain-without proper consideration of long-term consequences); see also
Deputy Secretary of the Treasury Neal Wolin, Remarks to the Council of
Institutional Investors 4 (Apr. 12, 2010), http://www.ustreas.gov/
press/releases/tg636.htm (noting that ``irresponsible pay practices . .
. led so many firms to act against the interests of their
shareholders''); IWG Report supra note 1, at 22.
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More specifically, a common element in the failure of Lehman
Brothers, American International Group, Fannie Mae, Washington Mutual,
and many other companies implicated in the 2008 financial meltdown, was
that their boards of directors did not control excessive risk-taking,
did not prevent compensation systems from encouraging a `bet the ranch'
mentality, and did not hold management sufficiently accountable.\7\ As
famed investor Warren Buffett observed in his 2009 letter to the
shareowners of Berkshire Hathaway Inc.:
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\7\ See, e.g. Press Release, CalPERS, Investors Speak Out on Dodd's
Financial Reform Bill--Offer Do's, Don'ts as Bill Reaches Critical
Stage 2 (Mar. 19, 2010), http://www.calpers.ca.gov/index.jsp?bc=/about/
press/pr-2010/mar/investors-financial-reform-bill.xml.
In my view a board of directors of a huge financial institution
is derelict if it does not insist that its CEO bear full
responsibility for risk control. If he's incapable of handling
that job, he should look for other employment. And if he fails
at it--with the Government thereupon required to step in with
funds or guarantees--the financial consequences for him and his
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board should be severe.
It has not been shareholders who have botched the operations of
some of our country's largest financial institutions. Yet they
have borne the burden, with 90 percent or more of the value of
their holdings wiped out in most cases of failure.
Collectively, they have lost more than $500 billion in just the
four largest financial fiascos of the last 2 years. To say
these owners have been ``bailed-out'' is to make a mockery of
the term.
The CEOs and directors of the failed companies, however, have
largely gone unscathed. Their fortunes may have been diminished
by the disasters they oversaw, but they still live in grand
style. It is the behavior of these CEOs and directors that
needs to be changed: If their institutions and the country are
harmed by their recklessness, they should pay a heavy price--
one not reimbursable by the companies they've damaged nor by
insurance. CEOs and, in many cases, directors have long
benefited from oversized financial carrots; some meaningful
sticks now need to be part of their employment picture as
well.\8\
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\8\ Letter from Warren E. Buffett, Chairman of the Board, to the
Shareholders of Berkshire Hathaway, Inc. 16 (Feb. 26, 2010), http://
www.berkshirehathaway.com/letters/2009ltr.pdf.
Accountability is critical to motivating people to do a better job
in any organization or activity.\9\ An effective board of directors can
help every business understand and control its risks, thereby
encouraging safety and stability in our financial system and reducing
the pressure on regulators, who, even if adequately funded, will be
unlikely to find and correct every problem.\10\ Unfortunately, long-
standing inadequacies in corporate governance requirements and
practices have limited shareowners' ability to hold boards
accountable.\11\
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\9\ Press Release, supra note 5, at 2.
\10\ Id.
\11\ IWG Report, supra note 1, at 22 (``shareowners currently have
few ways to hold directors' feet to the fire'').
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Fortunately, Dodd-Frank contains a number of corporate governance
reforms that when fully implemented and effectively enforced will
reduce those inadequacies by providing long-term investors like with
better tools, including better information, to hold directors more
accountable going forward.\12\
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\12\ S. Comm. On Banking, Housing, & Urban Affairs, Rep. On The
Restoring American Financial Stability Act 30 (Mar. 22, 2010), http://
banking.senate.gov/public/_files/RAFSAPostedCommitteeReport.pdf.
(Noting that the Senate version of Dodd-Frank contained provisions
designed to give investors ``more protection'' and shareholders ``a
greater voice in corporate governance'') [hereinafter S. Rep.].
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The remainder of my testimony highlights some of the key corporate
governance provisions of Dodd-Frank and why CalPERS believes those
provisions are beneficial to investors in terms of improving the
accountability of boards and enhancing investor protection.
Dodd-Frank Corporate Governance Provisions
SEC. 971 Proxy Access
The most fundamental of investor rights is the right to nominate,
elect and remove directors.\13\ Anything less provides a fundamental
flaw in capitalism. The providers of capital need to be able to hold
boards accountable, and boards in turn need to have effective oversight
of management. The United States is virtually alone in world markets by
not providing capital providers the ability to hold their stewards to
account. Several roadblocks, however, have prevented this fundamental
right from being an effective remedy for shareowners dissatisfied with
the performance of their public companies.\14\
---------------------------------------------------------------------------
\13\ See IWG Report, supra note 1, at 22.
\14\ Id.
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One of the most significant roadblocks is that Federal proxy rules
have historically prohibited shareowners from placing the names of
their own director candidates on public company proxy cards.\15\ Thus,
long-term shareowners who may have wanted the ability to run their own
candidate for a board seat as a means of making the current directors
more accountable have only had the option of pursuing a full-blown
election contest--a prohibitively expensive action for most public
pension funds like CalPERS.\16\
---------------------------------------------------------------------------
\15\ Id.
\16\ Id.
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Fortunately, due to the extraordinary leadership of this Committee
and the U.S. Securities and Exchange Commission (``Commission or
SEC''), this roadblock--the inability for shareowners to place director
nominees on the company's proxy card--we hope will soon be lifted.\17\
As background, in June 2009, the Commission issued a thoughtful
proposal providing for a uniform measured right for significant long-
term investors to place a limited number of nominees for director on
the company's proxy card.\18\ Some opponents of the proposal
subsequently raised questions about whether the Commission had the
authority to issue a proxy access rule.\19\ In response, Senator
Schumer introduced, what would later become Section 971 of Dodd-Frank,
removing any doubt that the Commission had the authority to issue a
proxy access rule.\20\
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\17\ We note that a second roadblock to the fundamental right of
investors to nominate, elect, and remove directors--``plurality
voting''--was not addressed by Dodd-Frank and remains a significant
impediment to improving board accountability. More specifically, most
companies elect directors in uncontested elections using a plurality
standard, by which shareowners may vote for, but cannot vote against, a
nominee. If shareowners oppose a particular nominee, they may only
withhold their vote. As a consequence, a nominee only needs one ``for''
vote to be elected and, therefore, potentially unseating a director and
imposing some accountability becomes virtually impossible. We would
respectfully request that the Committee consider stand alone
legislation to remove this roadblock. Id.
\18\ Facilitating Shareholder Director Nominations, 74 Fed. Reg.
29,024 (proposed rule June 18, 2009), http://www.sec.gov/rules/
proposed/2009/33-9046.pdf.
\19\ Facilitating Shareholder Director Nominations, 75 Fed. Reg.
56,668, 56,674 (final rule Sept. 16, 2010), http://www.gpo.gov/fdsys/
pkg/FR-2010-09-16/pdf/2010-22218.pdf (``Several commentators challenged
our authority to adopt Rule 14a-11'').
\20\ See id.
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After careful consideration of the input received in response to
two separate comment periods on the proposal, the SEC issued a final
rule on September 16, 2010.\21\ The final rule provides the ability for
CalPERS, as part of a larger group of long-term investors, to place a
limited number of nominees for director on the company's proxy card
and, thereby, effectively exercise its traditional right to nominate
and elect directors to company boards.\22\
---------------------------------------------------------------------------
\21\ Id. at 56,668.
\22\ Id.
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Unfortunately, despite Section 971 of Dodd-Frank, opponents of the
Commission's final rule have chosen to sue the SEC to delay its
implementation.\23\ The legal challenge, based largely on
Administrative Procedure Act grounds, is currently before the D.C.
Circuit Court of Appeals (``Court'') on an expedited review.\24\ A
decision is expected this summer.\25\ Whatever the Court's decision, we
fully expect that the Commission will, after curing any administrative
deficiencies, promptly implement the final rule and remove this long-
standing roadblock to the exercise of shareowners' fundamental right to
nominate, elect, and remove directors.
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\23\ Ted Allen, U.S. Appeal Court to Hear Proxy Access Lawsuit, ISS
(Apr. 6, 2011), http://blog.riskmetrics.com/gov/2011/04/us-appeals-
court-to-hear-proxy-access-lawsuit.html.
\24\ Id.
\25\ Id.
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SEC. 951 Shareholder Vote on Executive Compensation Disclosures
As described by the Financial Crisis Inquiry Commission, the
financial crisis revealed compensation systems:
[D]esigned in an environment of cheap money, intense
competition, and light regulation--too often rewarded the quick
deal, the short-term gain--without proper consideration of
long-term consequences. Often those systems encouraged the big
bet--where the payoff on the upside could be huge and the
downside limited. This was the case up and down the line--from
the corporate boardroom to the mortgage broker on the
street.\26\
---------------------------------------------------------------------------
\26\ FCIC Report, supra note 1, at xix.
During the development of Dodd-Frank, this Committee concluded that
``shareholders, as the owners of the corporation had a right to express
their opinion collectively on the appropriateness of executive
pay.''\27\ The result was Section 951 of Dodd-Frank that provides that
any proxy for an annual meeting of shareowners will include a separate
resolution subject to shareowner advisory vote to approve the
compensation of executives.\28\
---------------------------------------------------------------------------
\27\ S. Rep., supra note 10, at 109.
\28\ Id.
---------------------------------------------------------------------------
We agree with the Council of Institutional Investors that Section
951 provides with:
a tool . . . [to] effectively, efficiently and regularly
provide boards with useful feedback about whether investors
view the company's compensation practices to be in shareowners'
best interests. Nonbinding shareowner votes on pay offer a more
targeted way to signal shareowner discontent than withholding
votes from compensation committee members, and can serve as a
helpful catalyst and starting point for dialogue on excessive
or poorly structured executive pay. Also, the possibility of a
majority ``against'' vote might serve as an additional
deterrent against devising incentive plans that promote
excessive risk-taking and/or enrichment.\29\
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\29\ Letter from Justin Levis, Senior Research Associate, Council
of Institutional Investors to Mr. Mike Duignan, Head of Market
Supervision, Irish Stock Exchange 1-2 (Aug. 11, 2010), http://
www.cii.org/UserFiles/file/resource%20center/correspondence/2010/8-11-
10CIILetter
IrishCorpGovCode%20.pdf.
Section 951 became effective for the first time this proxy season.
As recently discussed by SEC Commissioner Luis Aguilar, it appears that
---------------------------------------------------------------------------
the new requirement is benefiting investors in at least three ways:
First, say-on-pay seems to have resulted in increased
communication between shareholders and corporate management.
Reports seem to indicate that both shareholders and corporate
management are pro-actively initiating discussions regarding
executive compensation, which is far from the predictions that
say-on-pay would lead to disrepair or at best be ineffective--
this sounds like a positive development to me.
Second, the reports indicate that shareholders are making their
voices heard. For example, as of this month, 31 public
companies have failed to obtain majority support for their
executive compensation packages.
Lastly, some pay practices appear to be changing in deference
to shareholders' views. Some companies have actually altered
the pay and benefits of top executives. Many companies are
putting in more performance-based compensation plans and they
are addressing items that shareholders often criticized, such
as: excessive severance; perks; Federal income tax payments;
and pensions. For example, approximately 40 of the Fortune 100
companies have eliminated policies that had the company pay
certain tax liabilities of executives. As another example,
General Electric modified the pay of its CEO 2 weeks prior in
anticipation of the shareholder vote, deferring the vesting of
certain options and conditioning the vesting on whether the
company meets certain performance targets. According to news
reports, this was apparently done to avoid losing a say-on-pay
vote.\30\
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\30\ Commissioner Luis A. Aguilar, U.S. Securities and Exchange
Commission, Speech at the Social Investment Forum 2011 Conference 3-4
(June 10, 2011), http://www.sec.gov/news/speech/2011/spch061011laa.htm.
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Section 954 Recovery of Erroneously Awarded Compensation
Another means identified by this Committee, the Investors Working
Group, the Council of Institutional Investors, and many other parties
to combat poorly structured executive pay plans that rewarded short
term but unsustainable performance was to enhance current clawback
provisions on unearned executive pay.\31\ In response, Section 954 of
Dodd-Frank strengthens the existing clawback provisions in three
important ways: First, it expands the application of the existing
clawback requirements to any current or former executive officer (not
just the CEO or CFO).\32\ Second, it clarifies that a clawback is
triggered by an accounting restatement due to material noncompliance
without regard to the existence of misconduct.\33\ Finally, it
strengthens the existing clawback requirements by extending the
clawback to 3 years from the existing 12-month period.\34\
---------------------------------------------------------------------------
\31\ See, e.g., Letter from Laurel Leitner, Senior Analyst, Council
of Institutional Investors to Robert E. Feldman, Executive Secretary,
Federal Deposit Insurance Corporation 1-2 (May 19, 2011), http://
www.fdic.gov/regulations/laws/Federal/2011/11c07Ad73.PDF.
\32\ John E. McGrady, III, & Kristen R. Miller, Executive
Compensation Clawbacks--Effective Deterrent or Effective Remedy?, BNA
Insights, Daily Rep. Executives, at B-4 (July 7, 2011).
\33\ Id.
\34\ Id.
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CalPERS' support for Section 954 is based on our belief, shared by
the Council of Institutional Investors, and many other corporate
governance and compensation experts, that a tough clawback policy is an
essential element of a meaningful pay for performance philosophy.\35\
If executives are rewarded for hitting their performance metrics--and
it later turns out that they failed to do so--they should return to
shareowners the pay that they did not rightly earn.\36\ We look forward
to the Commission's proposed and final rules to implement Section 954
scheduled for later this year.
---------------------------------------------------------------------------
\35\ Letter from Laurel Leitner, supra note 29, at 1.
\36\ Id.
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Section 973. Disclosures Regarding Chairman and CEO Structures
Finally, as indicated, the financial crisis represented an enormous
failure of board oversight of management. We share the view of the
Council of Institutional Investors, the Investor's Working Group and
many others that board oversight may be weakened by forceful CEO's who
also serve as a chair of the board.\37\ In our view, Independent board
chairs are a key component of robust boards that can effectively
monitor and, when necessary, rein in management.\38\ To have the CEO
effectively running the board means the oversight process is
fundamentally comprised. No one can grade their own performance
objectively. Independent board oversight of the CEO is vital.
---------------------------------------------------------------------------
\37\ Letter from Justin Levis, Senior Research Associate, Council
of Institutional Investors, to Jose Manuel Barroso, President, European
Commission 1-2 (Aug. 31, 2010), http://www.cii.org/UserFiles/file/
resource%20center/correspondence/2010/CII%20Letter%20on%20EC
%20Green%20Paper%20on%20Bank%20Governance%208-31-10%20final.pdf.
\38\ Id.
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While not requiring the separation of the role of the chair and
CEO, Section 973 of Dodd-Frank provides an important step forward by
directing the SEC to issue rules, which are already in place, requiring
those companies who have a Chairman/CEO structure to disclose an
explanation of the reasons that it has chosen that structure.\39\ This
is an important advancement in corporate governance disclosure that we
continue to support.
---------------------------------------------------------------------------
\39\ S. Rep., supra note 10, at 119.
---------------------------------------------------------------------------
That concludes my testimony. Thank you, Mr. Chairman for inviting
me to participate at this hearing. I look forward to the opportunity to
respond to any questions.
______
PREPARED STATEMENT OF PAUL S. ATKINS *
Visiting Scholar, American Enterprise Institute for Public Policy
Research
July 12, 2011
Thank you very much, Mr. Chairman, Ranking Member Shelby, and
Members of the Committee, for inviting me to appear today at your
hearing. It is an honor and privilege for me to provide information for
your deliberations on Dodd-Frank and the SEC.
---------------------------------------------------------------------------
* The views expressed in this testimony are those of the author
alone and do not necessarily represent those of the American Enterprise
Institute.
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Dodd-Frank Overview
I come before you today not only as a former Commissioner of the
Securities and Exchange Commission and member of the former
Congressional Oversight Panel for the TARP, but also as a visiting
scholar at the American Enterprise Institute for Public Policy
Research. AEI has a long history of focus on the economic and
psychological fundamentals of entrepreneurism, economic development,
and the political economy. It is a privilege for me to be able to
participate in the public discussion about the issues of the day in the
context of my years of work in the public and private sector.
The news of this past week has highlighted the disappointing state
of affairs in our economy. The data released by the Bureau of Labor
Statistics show the unemployment rate increasing to 9.2 percent, while
the labor force itself shrank by more than a quarter of a million
people. Basically, unemployment has risen as the supply of available
workers has shrunk. More than 14 million Americans are out of work--and
almost half of those have been out of work for more than 6 months.
In a productive economy, jobs are normally created by people with
entrepreneurial spirit--whether small businesses or large corporations.
Starting with an idea for a product or service and the risk appetite to
make it a reality, the entrepreneur will need to engage the help of
others to make it a reality. To hire people and develop their product,
entrepreneurs of course need money. The money has to come from
somewhere, and with efficient financial markets, an entrepreneur should
be able to borrow the money or find others willing to invest in the
idea--risk their own capital for an interest in the potential profits.
We have a great debate in this country as to whether there is a
shortage of credit supply or demand. Last year, as a member of the
Congressional Oversight Panel, I had the privilege of testifying before
the House Financial Services Committee regarding small business lending
initiatives. The debate was then, as it is now, whether the issuance of
credit is constrained because of a lack of demand or a shortage of
supply. Regardless of the cause, in the current regulatory climate it
is difficult for lenders to increase their small business lending.
Small businesses produce most of the new jobs in the country. From my
work on the Congressional Oversight Panel, we heard many anecdotal
reports from our field hearings and elsewhere that bank examiners have
become more conservative and have required increasing levels of capital
since the advent of the financial crisis. The balance between
sufficient regulation and over-regulation is often a fine one. We have
to remember that it is the investors who pay for regulation--effective
or otherwise--through higher prices, diminished returns, or restricted
choices.
Why do I go through this description of how jobs are created?
Because confidence and certainty are crucial to fostering a business
climate that creates jobs. It is my belief that a major cause of the
uncertainty handcuffing our economy today is in fact Government policy,
particularly the sweeping new financial law enacted last year
ostensibly for the sake of market stability and investor confidence.
Because many of the provisions were not directly related to the
underpinnings of the financial crisis, investors ultimately will pay
for the increased costs associated with the mandates without receiving
commensurate benefits.
That is the single tragedy of Dodd-Frank. It is a calamity--2,319
pages are aggravating uncertainty and undermining the climate necessary
for economic growth. Yet considering its length and scope, the Dodd-
Frank Act was passed with relatively few hearings and no real debate
about provisions that now threaten economic growth. In contrast,
following the market crash of 1929, Congress attempted comprehensive
reform over a period of a decade, involving extensive hearings and
public debate. Dodd-Frank calls for the creation of anywhere between
243 and 533 new rules, depending on how you count them, and 84 rules by
3 new agencies alone--the Consumer Financial Protection Bureau (CFPB),
the Office of Financial Reporting (OFR), and the Financial Stability
Oversight Council (FSOC). Each of these new agencies has far-reaching
powers, and we will not know for years how they will develop. Legal
challenges are inevitable, not just as to the technicalities of the
rules and whether they have been properly promulgated, but also as to
basic questions of jurisdiction and constitutionality.
As the past year has shown, Dodd-Frank also mandates very tight
deadlines for Federal agencies to draft and implement these rules. In
this quarter alone, Dodd-Frank mandates more than 100 rules to be
finalized.\1\ As some experts have noted previously,\2\ this rate of
rulemaking required by Dodd-Frank far outpaces the agencies' respective
historical workloads. From 2005-2006 the SEC annually averaged 9.5 new
substantive rules, while the CFTC averaged 5.5. Post-Dodd-Frank those
numbers have soared to an average of 59 new rules for the SEC and 37
for the CFTC.\3\ Members of this committee have previously expressed
concern that Federal agencies are sacrificing quality for speed as they
neglect to properly weigh the costs and benefits to the economy of
their proposed rules. In these circumstances, something has to give,
and so far we have seen very little in the way of cost benefit analysis
(some agencies' inspectors general are investigating whether this lack
of analysis may have violated the Administrative Procedure Act and
other mandates), contracted timelines for the public to comment on
proposed rulemakings (most comment periods are about 20 days shorter
than usual), missed deadlines (right before the statutory effective
date, registration requirements under Title IV had to be delayed by 8
months because the rules were finalized so late), and proposed
rulemaking that is vague or overly broad. Taken together, the ability
of stakeholders to provide input on matters directly impacting their
business is severely impaired.
---------------------------------------------------------------------------
\1\ See Promoting Economic Recovery and Job Creation: Hearing
before the H. Comm. on Financial Services, 112th Cong., 1st Sess. (Jan.
25, 2011) (statement of Hal H. Scott, Professor, Harvard Law School).
\2\ Id.
\3\ Id.
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An example on the latter point can be found with the Financial
Stability Oversight Council (FSOC), a new agency created by Title I to
identify threats to the financial stability of the United States. While
this seemed like an attractive idea to officials who wish never to
relive the anxiety of the ``Too Big to Fail'' era, the realities and
impracticalities of such a Council have already started to reveal
themselves.
The principal new authority assigned to FSOC is to identify
systemically important financial institutions. FSOC's proposed
rulemaking in January 2011 regarding this process was roundly
criticized by the public and bipartisan Members of Congress for merely
parroting the broad statutory language. This lack of transparency--
magnified by leaks to the media about the staff's methodology under
consideration--has only compounded market uncertainty. FSOC recently
announced plans to provide further guidance of this most important
authority of the new systemic risk regulatory regime--although the form
and extent of that guidance remains to be seen.
The activities of the Financial Stability Oversight Council
(including OFR) and the Bureau of Consumer Financial Protection have
received much scrutiny over the past year, and for good reason. They
comprise just 2 of the Act's 16 Titles, however, and so I welcome
today's hearing on the subject of the investor protection provisions.
As I intend to make clear today, many of these provisions impose
sweeping changes, yet received relatively little attention during
consideration of last year's Dodd-Frank Act, which naturally raises the
likelihood of unintended consequences.
Title IV: The Private Fund Investment Advisers Registration Act of 2010
Under Title IV of Dodd-Frank, investment advisers to hedge funds
and private equity firms are required to comply with a set of
registration rules, which hinders the success of both investors in the
funds by adding administrative costs and potentially keeping
competitors out of the market, and the SEC by spreading its resources
too thinly and diverting its attention from protecting retail
investors. This situation, together with the likely mistaken sense of
security that investors might infer from SEC registration, endangers
all investors.
By repealing the ``15-client'' exemption, Title IV effectively
forces all investment advisers managing more than $150 million in
assets to register with the SEC. The Commission estimates that this
will bring 3,200 advisers under its supervision. The rules recently
finalized by the SEC specify the exemptions provided by Dodd-Frank for
advisers solely to venture capital funds, foreign private advisers, and
family offices. The rulemaking was not completed until close to the
deadline before which advisers were originally required to register.
Prior to the adoption of the rule, the SEC allowed the affected
entities to wonder for several months through rumor and staff
statements if, when, and in what form the requirement might come into
effect.
Why do we have this new registration process? One narrative has
been that supposed ``deregulation'' during the past 6, 10, or 15
years--you pick the time period--led to the crisis. But, one can hardly
say that the past 6-15 years have been deregulatory. In the United
States we had Sarbanes-Oxley, new SEC rules, new stock exchange and
NASD/FINRA rules, and new accounting rules. We saw the financial crisis
hit regulated entities around the world, even in countries like Germany
and France that one could hardly characterize as deregulatory.
Regulators and lawmakers abroad, especially in Europe, have tried
to blame hedge funds and short selling. Hedge funds were supposedly
over-leveraged and drove the demand for esoteric securities. This
narrative claims they shorted all kinds of assets during the 2008
crisis, driving the market down and creating panic.
It will be surprising for subscribers to the popular narrative to
learn that hedge funds overall had the least leverage, at 2:1.\4\
Compare that to other financial institutions at the time, which had
significantly higher leverage ratios. Taking short positions, in turn,
is an important investment activity as it helps to provide liquidity
and points out excessive valuations. I have yet to see a compelling
argument for why the price declines and flagging investor confidence
experienced in 2008 might be attributed to hedge funds' shorting
activities rather than the obvious decline in economic and business
fundamentals.
---------------------------------------------------------------------------
\4\ See Andrew Ang, et al., Hedge Fund Leverage 19 (Jan. 25, 2011)
available at http://www2.gsb.columbia.edu/faculty/aang/papers/
HFleverage.pdf.
---------------------------------------------------------------------------
The costs borne by registering advisers, and in turn by their
pension, institutional and private individual investors, are real and
significant. Sending off the registration form is the deceptively easy
part. Registered advisers will have to bear numerous administrative,
legal, and personnel costs.
In the recently adopted rules, advisers exempted from registration
requirements would still be required under Sections 407 and 408 to
comply with some of the same reporting requirements as registered
advisers. For example, venture capital advisers would be subject to
examination and recordkeeping requirements. For venture capital firms
especially, it is not clear what the investor protection rationale is.
This construct seems to be contrary to the intent of Section 407; if
so, this committee has an oversight interest in the new rules for
exempt reporting advisers.
Obviously this shakeup will be particularly hard on smaller hedge
funds and private equity firms, which have fewer resources all around.
As some have already argued, this new regulatory structure has the
potential to raise barriers to entry and drive segments of the industry
overseas. In the end, all of this may add many more costs to an economy
that can scarcely afford it.
Under proposed rulemaking passed earlier this year, a new reporting
requirement will be imposed on all registered advisers known as Form
PF. As proposed, Form PF is unprecedented in scope and detail: it is 44
pages long in its entirety. All registered private fund advisers would
be required to file Form PF at least annually, and large advisers would
be required to file quarterly. Advisers will be required to complete
different sections based on their fund type and size, and the reporting
burden increases exponentially for large firms. For example, advisers
to private equity funds of at least $1 billion would have to file Form
PF within 15 days of quarter's end, including possibly detailed
information on their portfolio company holdings.
Requiring registered advisers to compile and report all this
detailed information represents an enormous regulatory burden that
provides no appreciable benefit to investors. Demonstrably, much like
many other Federal agencies, in the SEC's rush to draft and implement
rules in accordance with Dodd-Frank's statutory deadlines, it has not
properly weighed the costs and benefits. The industry has raised
numerous concerns with the draft rule, and I hope the SEC will consider
the implications of Form PF carefully.
As the following chart \5\ illustrates, since 2008 the number of
examinations has actually been decreasing because of management
priorities and allocation of resources. The flood of new registrants
will only dilute the SEC's resources, and further reduce the frequency
or scope of examinations. The allocation of resources in this area is
critical--it should not be forgotten that in the case of the largest
Ponzi scheme ever perpetrated, Bernard L. Madoff Investment Securities
was both a registered broker-dealer and a registered adviser subject to
regular SEC examinations.
---------------------------------------------------------------------------
\5\ See United States Securities and Exchange Commission, Study on
Enhancing Investment Adviser Examinations 15 (Jan. 2011) available at
http://www.sec.gov/news/studies/2011/914studyfinal.pdf.
Title IX: The Investor Protection and Securities Reform Act of 2010
Moving on to Title IX. Title IX encompasses a wide range of issues
including credit rating agencies, whistleblowing, fiduciary duties, and
SEC management.
Credit Rating Agencies
This Committee took action with the Credit Rating Agency Reform Act
of 2006 to address the troubling oligopoly of credit rating agencies
and the SEC's opaque method of designating nationally recognized
statistical rating organizations (NRSROs). Unfortunately, the SEC had
never addressed these issues in the 30 years after instituting the
NRSRO designation. The framework adopted in 2006 (unfortunately too
late to forestall the crisis) aimed to encourage transparency and
competition among rating agencies. That approach, unfortunately, has
been undermined by some provisions of Dodd-Frank that set up an
expectation for ultimately unachievable regulatory control.
After the financial crisis, credit rating agencies were under fire
for their faulty methodologies and conflicts of interest. To combat
this, the SEC has requested comment for a study on the feasibility of
standardizing credit ratings and has proposed hundreds of pages of new
rules. Addressing problems of faulty methodologies and transparency,
the SEC has proposed rules requiring internal controls for determining
ratings, establishing professional standards for credit analysts, and
providing for greater public disclosure about credit ratings.
Dodd-Frank also gives the SEC the power to penalize credit rating
agencies for consistently inaccurate ratings. Further, Dodd-Frank also
raises the dubious possibility that the SEC would assess the accuracy
of ratings. It is unclear how that could ever be accomplished.
In an attempt to break up the oligopoly imposed by the three
largest credit rating agencies, the SEC has proposed rules to remove
references to credit ratings from regulations, pursuant to authority
under Section 939. In addition, the SEC has alleviated the problem of
conflicts of interest by precluding ratings from being influenced by
sales and marketing and by enhancing a ``look-back'' review to
determine whether any conflicts of interest influenced a rating.
Unfortunately, Dodd-Frank has taken an inconsistent approach with
respect to credit rating agencies. With respect to sovereign debt, the
threats currently being levied by government officials in Europe
demonstrate that rating agencies are susceptible to political pressure
as to the ``correctness'' of their ratings. Congress should
consistently push transparency and competition so that investors get
high-quality and objective advice from credit rating agencies.
Whistleblower Programs
Dodd-Frank provides that the SEC and the CFTC may award
whistleblowers from 10 percent to 30 percent of monetary sanctions
collected in enforcement actions.\6\ Two special funds of $300 million
and $100 million are set up for the SEC and CFTC, respectively, to
ensure payment of whistleblowers. Dodd-Frank provides that
whistleblowing employees can hire attorneys and that they must hire an
attorney if they wish to remain anonymous. One can imagine what
percentage of the 10 percent-30 percent take the lawyers will demand
from the whistleblower.
---------------------------------------------------------------------------
\6\ Section 922 provides for the SEC's whistleblower program.
Section 748 provides for the CFTC's whistleblower program.
---------------------------------------------------------------------------
Dodd-Frank clearly aims to encourage whistleblowers and ease their
fears of retaliation, ostracism, and reputational damage for future
employment-all authentic concerns for legitimate protesters. But it
creates perverse incentives as well, and sets up a system that has many
inherent problems. For example, if an employee approaches an attorney
with a potential claim of less than $1 million, what will the attorney
advise if the problem is ongoing and is likely to result in a
settlement of more than $1 million at some time in the future? Will the
attorney advise the employee to report it immediately, or to remain
quiet until the problem crosses the compensation threshold? Moreover,
the unintended consequences of unfounded charges from disgruntled
employees with ulterior motives will be devastating for shareholders.
Of course, this only considers the employee side of the system. From
the SEC's side, how will it cope with effectively investigate the
potentially overwhelming number of tips? The Bernie Madoff case is
again an apt reminder.
Already, a company must hire attorneys and accountants to
investigate almost any purported complaint, with strict policies and
procedures to ensure due process. The injection of plaintiffs'
attorneys into the mix increases the potential for specious claims to
get traction and win a settlement, especially if the complainant is
anonymous. Congress has skewed the delicate balance between good policy
and over-indulgence of accusations.
Despite comments to the contrary, the SEC chose not to make
mandatory internal reporting to a company's own compliance program.
Because the bounties available to whistleblowers (and their attorneys)
are so large, and because the SEC chose not to make internal reporting
mandatory, whistleblowers are incentivized to ``report out'' directly
to the SEC rather than to ``report up'' through their companies'
compliance programs. Thus, the rule undermines internal compliance
programs. Moreover, companies have no protection from disclosure of
confidential information, and there is no real way to sanction a false
whistleblower, absent ``bad faith''--which is a tough standard to meet.
Fiduciary Duty
Under Section 913, the SEC was required to conduct a study on
harmonizing the standard of care for investment advisers and broker-
dealers. Under the Investment Advisers Act of 1940 and Supreme Court
precedent, advisers have been deemed to owe a ``fiduciary duty'' to
their clients whereas broker-dealers are subject to standards imposed
by the Securities Exchange Act of 1934 and their self-regulatory
organizations. The SEC has recommended to Congress that it harmonize
these concepts into a uniform standard.
Under the 1934 Act and SRO rules, broker-dealers ultimately are
held to a very high standard of care that has benefited investors for
many years. With respect to an advisory relationship, any dispute
ultimately will likely be judged through a lawsuit in State court under
terms of the advisory contracts, which tend to be long and include many
disclaimers of conflicts of interest. On the other hand, broker-dealers
are subject to broad standards of practice that the SEC and FINRA have
adopted and interpreted over the years, as well as a low-cost
arbitration system.
It is important to remember that not all investors are the same.
Some investors perhaps want and need a fiduciary who possesses intimate
knowledge of their financial condition and can advise accordingly. On
the other hand, some investors would prefer to have a true broker who
is engaged on a transaction basis and is compensated accordingly. These
two kinds of activities should have different standards of care
attached to them. When the SEC turns to rulemaking later this year, as
it has indicated it plans to do, it should respect the different needs
of different investors.
At the same time, the Department of Labor is pursuing a separate
rulemaking that aims to increase the ambit of fiduciary duty within the
context of ERISA plans. Unfortunately, this Labor Department initiative
does not seem to be coordinated with the SEC and carries potentially
profound effects for the retirement plan market and the availability of
product offerings.
SEC Management
Title IX contains many other provisions, most of which have nothing
to do with the causes of the financial crisis. In my short window of
time before you, I cannot discuss all of these sections. Suffice it to
say that many sections respond to long-standing requests of special
interest groups. The SEC's compliance with these provisions has been
spotty: The ink was not even dry on Dodd-Frank when the SEC gave a new
Federal right for some shareholders to be able to nominate corporate
board members directly instead of going through the normal process by
which directors are nominated. This rulemaking is being challenged in
Federal court. Yet, the SEC has neglected Section 965, the intent of
which was to direct the SEC to disband the Office of Compliance
Inspections and Examinations and return the examiners to the Divisions
of Investment Management and Trading and Markets.
Just last week the SEC chairman testified about the recent leasing
decision and suggested that the SEC should no longer have leasing
authority. In contrast, last year, some were suggesting the SEC should
have a self-funding mechanism outside of the normal congressional
appropriations process. In the meantime, the SEC has pursued an
extremely divisive agenda, marked by more than a dozen 3-2 votes in the
past 2 years alone. I have never witnessed such division--this record
is in marked contrast to my experience of 10 years as staffer in two
chairman's offices and as a commissioner under three chairmen. The
dissenters are reasonable people and their dissents are not always
fundamentally opposed to the rulemaking itself. The sad fact is that it
appears that the leadership of the SEC does not engage effectively on
the finer points of the policy issues. Thus, I encourage this Committee
to continue to exercise oversight of SEC management.
Dodd-Frank attempted to focus on organizational and managerial
issues at the SEC, but it wound up, in effect, micro-managing and
making things more complicated. Section 911 codifies in statute the
Investor Advisory Committee that the current chairman established,
which itself was similar to the Consumer Affairs Advisory Committee
that I helped Chairman Levitt establish when I worked in his office in
the mid-1990s. This statutory provision etches in stone one way of
doing things to the exclusion of others. We shall see how the Investor
Advocate, an independent office established under Section 915,
ultimately develops. The statute thus adds yet another direct report to
the chairman, who already has more direct reports than is practicable.
Management philosophies like Total Quality Management and Six Sigma
teach that in any organization, measurement drives human behavior
because the incentive is to try to meet the measurement criteria (``You
get what you measure'').
For example, Enron was not reviewed for years because review
personnel were judged by how many filings they reviewed, not
necessarily by the quality of their review. The incentive was to
postpone review of the complicated Enron filing because one could
review many others in the time it would take to review Enron. By the
late 1990s, this focus on numbers more than quality had decreased staff
morale so much that employees began to organize to form a union.
Despite management's campaign to thwart it, in July 2000, SEC employees
voted overwhelmingly to unionize the workforce.
The emphasis on numbers over quality also affects behavior in the
enforcement division and examination office. Every enforcement attorney
knows that statistics (or ``stats'') help to determine perception and
promotion potential. The statistics sought are cases either brought and
settled or litigated to a successful conclusion, and amount of fines
collected. These statistics do not necessarily measure quality (such as
an investigation performed well and efficiently, but the evidence
ultimately adduced did not indicate a securities violation). Thus, the
stats system does not encourage sensitivity to due process.
In addition, the stats system tends to discourage the pursuit of
penny stock manipulations and Ponzi schemes, which ravage mostly retail
investors. These frauds generally take a long time and much effort to
prove--the perpetrators tend to be true criminals who use every effort
to fight, rather than the typical white-collar corporate violator of a
relatively minor corporate reporting requirement who has an incentive
to negotiate a settlement to put the matter behind him and preserve his
reputation and career. Thus, over the years several staff attorneys
have told me that their superiors ``actively discourage'' them from
pursuing Ponzi schemes and stock manipulations, because of the
difficulty in bringing the case to a successful conclusion and the lack
of publicity in the press when these cases are brought (with the
exception of Madoff, these sorts of cases tend to be small). Some
senior enforcement officers openly refer to these sorts of cases as
``slip-and-fall'' cases, which disparages the real effect that these
cases have on individuals, who can lose their life savings in them.
Because of the interstate and international aspect of many of these
cases, if the SEC does not go after them, no one can or will.
Sadly, this attitude is reflected even outside the SEC. Just last
week, I saw a quotation in an article regarding the steps that the SEC
needs to take to collect on the settlements that it has entered into.
The sentiment expressed by the commenter was that many of the cases are
very small, but that the agency is under political pressure to go after
the smaller schemes. Not to discount the importance of combating any
fraud, we need to remember that one individual losing his entire life's
savings is extremely serious, even if it is ``only'' 5-digits in size.
During my tenure as commissioner, I emphasized the need to focus
from an enforcement perspective on microcap fraud, including Ponzi
schemes, pump-and-dump schemes, and other stock manipulations. I was a
strong advocate for the formation of the Microcap Fraud Group in the
Enforcement Division, which was finally formed in 2008. I had also
strongly supported the good efforts of the Office of Internet
Enforcement, established under Chairman Levitt in the late 1990s, which
worked closely with other law enforcement agencies to tackle Internet
and other electronic fraud. Unfortunately, it appears that while the
administrative overhead functions within enforcement are gaining
resources, insufficient attention is being paid to ``boots-on-the-
ground'' investigative resources to combat the pernicious frauds that
prey on individual investors.
There are many intelligent, competent, dedicated, hard-working
people at the SEC. It is the management system and how it determined
priorities over the past decade that has let them down. Three years
ago, in an article published in the Fordham Journal of Corporate and
Financial Law, \7\ I called for the SEC to follow the example from 1972
of Chairman William Casey, who formed a committee to review the
enforcement division--its strategy, priorities, organization,
management, and due-process protections. Thirty-seven years later, and
especially after the Madoff incident, this sort of review is long
overdue.
---------------------------------------------------------------------------
\7\ See Paul S. Atkins and Bradley J. Bondi, ``Evaluating the
Mission: A Critical Review of the History and Evolution of the SEC
Enforcement Program,'' 8 Fordham Journal of Corp. & Fin. Law 367
(2008).
---------------------------------------------------------------------------
Conclusion
Dodd-Frank overall is a poorly drafted statute that drastically
expands the power of the Federal Government, creates new bureaucracies
staffed with thousands, and does little to help the struggling American
citizen. Ambiguous language will result in frivolous and unnecessary
litigation. Huge amounts of power and discretion have been ceded to
regulators, who were given the impossible task of about a year or two
to put things in place. All of these costs and distractions will
further stifle economic growth. Consumers, investors, and workers will
pay the price. That is certainly not the best way to get the economy up
and running!
The Dodd-Frank Bill started out as a bill to ``get'' Wall Street
and morphed into a bill that sticks it to everyone--Wall Street, Main
Street, consumers, entrepreneurs, shareholders and taxpayers alike. The
financial markets are critically important to America. They raise
capital for businesses producing good and services. They create jobs,
fund ideas and increase wealth for all Americans. When Americans save
and invest, they are putting their capital to work, building their nest
egg and that of others, too. We need a more thoughtful, balanced plan
to make sure that the nest egg is as safe as it can be, but also to
ensure the we are not killing the proverbial, golden egg-laying goose.
The arguments over Dodd-Frank will continue. Regulators will continue
to grind away at implementing its provisions. There will continue to be
calls for repeal of all or parts of it. This will be a vital topic to
follow for the foreseeable future.
Thank you again for the invitation to come here and testify before
you today.
______
PREPARED STATEMENT OF LYNN E. TURNER
Former Chief Accountant, Securities and Exchange Commission
July 12, 2011
Thank you Chairman Johnson and Ranking Member Shelby for holding
this hearing and it is an honor to be invited to testify before you.
Our capital markets in the United States have been the crown jewel of
our economy for over two centuries. But in the last decade, they have
been the source of great scandal, resulting in investors questioning
whether they are on a level playing field or sitting across the table
at a casino where the odds are greatly stacked against them. This along
with a declining U.S. economy has led investors to invest increasing
amounts of capital overseas, with less available here for jobs,
investment in plant, and research and development. If that trend is to
be reversed, investors must know they will be afforded reasonable
protections and have regulators who serve as their advocates.
Background
Before I start, it might be worthwhile to provide some background
on my experience. I have held various positions in the accounting
profession for some 35 years. I started my career with one of the
world's largest international accounting and auditing firms where I
rose to become an audit and SEC consulting partner. I served as a CFO
and vice president of an international semiconductor company as well as
a business executive in a venture backed newly formed startup company.
I have had the good fortune to be the Chief Accountant of the
Securities and Exchange Commission (``SEC''). In addition, I have been:
a member of and chaired audit committees of corporate boards of both
large and small public companies; a trustee of a mutual fund and a
public pension fund; and a professor of accounting. In 2007, Treasury
Secretary Paulson appointed me to the U.S. Treasury Advisory Committee
on the Auditing Profession (``ACAP''). I have also served on the
Standing Advisory Group (``SAG'') and Investor Advisory Group (``IAG'')
of the Public Company Accounting Oversight Board (``PCAOB'').
The Financial Crisis
It has now been over 4 years since the worst post Great Depression
financial crisis imploded in this country and around the globe,
resulting in the Great Recession. The financial damage to civilization
was tremendous as Exhibit A illustrates; investors in the global
markets lost over $28 trillion in the value of their holdings. In the
United States, investors saw approximately $10-11 trillion in value
disappear, not including the value of their homes which continue to
depreciate. And consider the numbers: in 1930, 1.2 percent of the
population owned stock; in 2008, the number invested in the markets
through stock, mutual funds or retirement accounts approximated 110
million.
To put the damage to investors and the capital markets in greater
perspective, the Dow Jones Industrial Average closed on October 9, 2007
at 14,164.53 but then proceeded to plunge as fear grasped investors to
close at 6547.05 on March 9, 2009. That represents a fall during the
financial crisis of 7839.88 points or 54.9 percent. The S&P 500 closed
on October 9, 2007 at 1565.15. On March 9, 2009, it would close at
676.53, representing a fall of 898.36 points or 57.4 percent. By this
point in time, investors and the American public had lost confidence in
the capital markets, no longer trusted business executives, and
believed Wall Street had become a casino where the house odds were
overwhelming in favor of Wall Street, not Main Street. Congress had to
act.
Sound Financial Markets and Capitalism
My 35 years of experience as a businessman, regulator, and investor
have taught me that sound financial markets and efficient capitalism,
can only exist if built upon five fundamental bedrock pillars. These
pillars are:
1. Transparency--Investors must receive unambiguous financial
information that allows them to make fully informed decisions
as to which companies they should invest in.
2. Accountability--Those entrusted with the money millions of
Americans invest must be held accountable for how they use that
money. Business executives should be rewarded for sound
business decisions and long term performance. Their
compensation should be cut or they should be replaced when
underperforming. And investors must have redress when they have
been recklessly or worse yet, fraudulently wronged, such as
when credit rating agencies or public companies issue
misleading reports.
3. Independence--A lack of conflicts and where conflicts do exist,
clear and timely disclosure of those conflicts prior to
solicitation of investor's money.
4. Effective Regulators--Independent, strategic and balanced
regulators who understand their mission is necessary to protect
investors, create confidence in the markets and attract
capital. Effective regulation also requires that regulators be
held accountable by Congress in a timely manner.
5. Enforcement of the Laws--In the past, the United States has
prided itself as being a nation of laws. Those who break the
laws, should be held accountable so that the markets and all
market participants operate in a fair market place, and the
playing field is not tilted to any one party's advantage.
Yet when we look back of the mayhem of the past decade, we see that:
There was a dearth of transparency as investors and
regulators alike could not decipher the financial statements
and financial condition of institutions such as AIG, Lehman
Brothers and many of the largest banks in the country. Assets
and capital were inflated, liabilities understated and profits
upon which huge compensation packages granted, a mirage.
Regulation was most ineffective under the onslaught of
those who mistakenly thought the markets and market
participants could police themselves. These disciples of
laissez faire failed to understand the culture of markets and
power of greed and megalomania. At the same time, most of the
regulators were captured by industry, lacked adequate funding
and resources in the case of the SEC and CFTC, and lacked
authority to regulate such markets as derivatives which had
become increasingly toxic as they grew close to 10 times the
GDP of the entire world.
As the Senate's own investigations have illustrated,
conflicts abounded as institutions collected fees for
originating loans aptly named ``Liars'', ``No Doc'', or
``NINJA'', packaged them up for another fee, and then collected
even greater fees when they sold them off to an unsuspecting,
and poorly informed investing public. Conflicts were rampant
among credit rating agencies, the lawyers who drafted and
reviewed all these agreements, and auditors.
Things falsely done in the name of capitalism or
entrepreneurship, had nothing to do with them. As Charlie
Munger, Vice Chairman of Berkshire Hathaway recently said:
``None of us should fall for the idea that this was
constructive capitalism. In the 1920s they called it bucket
shops--just the name tells you it's bad--and they eventually
made it illegal, and rightly so. They should do the same this
time.''
And the public now questions whether the law enforcement
agencies have created a two tier justice system; one for Wall
Street and business executives and one for Main Street.
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
(``The Act'')
With that as a backdrop, Congress chose to act passing the Dodd-
Frank Wall Street Reform and Consumer Protection Act. I believe doing
nothing was not an option even though some have suggested that, or
something akin to fringe changes, more intent on maintaining the status
quo then protecting investors and consumers. And while I would have
preferred a Pecora style investigation as Senator Shelby had urged, it
is abundantly clear that was not going to happen in this city.
Accordingly, I applaud Congress for acting.
Within the Act, are Title IV, Private Fund Advisors and Title XI,
Investor Protection and Securities Regulation. I shall confine my
remarks to Title XI and certain of the strong investor protections
afforded within that section.
Whistle Blower Protection--Sections 922, 923, and 924
It is important the SEC become aware of securities law violations
at the earliest possible date, so that it can act to stop the violation
before further harm to investors and the markets occur, and it can hold
people accountable. Obtaining credible information is vital to early
action and successful prosecution by law enforcement agencies.
In its 2010 Global Fraud Study, The Association of Certified Fraud
Examiners stated that on average, it took 27 months for companies to
detect financial statement fraud. That's over 2 years investors would
be unknowingly investing based on false and misleading financial
information. The report also notes that the number one way in which
frauds are detected is not a management review, internal audit or
external auditors. Rather it is through tips.
Consistent with these findings, Dodd-Frank allows the SEC to reward
those who provide it with a wide range of information of securities
laws violations resulting in successful prosecutions. The SEC had very
limited authority to do so before passage of the Act. In fact, since
1989 and prior to Dodd-Frank, the SEC had only made seven payouts to
five whistleblowers for a total of $159,537.
The SEC adopted rules implementing the whistle blower sections of
Dodd-Frank in May of this year, after soliciting and receiving public
comments on the issue. While some from the business community feel the
rules as proposed will encourage people to report to the SEC without
going through the normal hot lines and compliance program a company
sets up, others felt they would cause some to avoid providing useful
tips to the SEC and result in tips showing up on the Internet at sites
such as Wiki Leaks.
Having served on audit committees of public companies, I believe
the SEC took a reasonable and balanced approach to the final rules it
adopted. Hot lines will not work unless employees have confidence their
identity will remain anonymous and protected, and the complaint will be
addressed in an unbiased thorough manner. This is especially important
as the business groups forming the Committee of Sponsoring
Organizations of the Treadway Commission (COSO), noted in a May 2010
report that in the 347 cases of fraudulent reporting brought by the SEC
from 1998 through 2007, the CEO and/or CFO were named in 89 percent of
the cases, up from 83 percent in the prior decade. I believe Dodd-Frank
and the new SEC rules will result in companies reexamining their hot
lines and compliance programs, ensuring employees can put their faith
in them.
The SEC provided reasonable protections for public companies. The
SEC encouraged those who provide tips, to go through the normal company
compliance channels. It did so stating that reporting internally will
be considered when the size of an award is determined by the SEC. The
Commission also provided individuals the opportunity to first report to
the company, and then if they chose, reporting to the SEC. This is very
beneficial from my perspective as it allows the company to act on the
information and where appropriate, self report to the SEC. In addition,
the SEC excluded payments to certain employees such as in house
counsel, compliance personnel, internal auditors, certain executives
and external auditors.
Enhanced Law Enforcement--Sections 925, 926, 929E, and 929KLMNOP
Dodd-Frank includes a number of beneficial provisions that will
enhance law enforcement giving investors greater protections and
ensuring fair markets. For example, under prior law, a securities
professional who had been barred by the SEC as a result of serious
misconduct as an investment advisor, could simply participate as a
broker dealer, offering similar services. Dodd-Frank appropriately
addressed this issue by giving the SEC the authority it sought to
impose collateral bars against regulated persons. Likewise, Dodd-Frank
prohibits someone already convicted of a felony in connection with a
securities offering, from offering securities under Rule 506 of
Regulation D. While the Act allows critical financing for startups, it
keeps felons from gaining a foothold in the process, reducing the
likelihood of fraud being perpetrated by repeat offenders.
Previously the SEC did not have the authority to bring claims and
seek penalties against those who recklessly and knowingly aided or
abetted others in a violation of the Securities Act of Investment
Company Act. In essence, certain individuals could ``drive the getaway
car'' when it came to a securities law violation and know they were
beyond the reach of the regulator and law. Dodd-Frank addressed that
problem. It also called for a study by the SEC on whether investors
should be given redress against these individuals. Today, professionals
including gatekeepers and investment bankers critical to a fair and
orderly market, can assist an individual in the commission of a
securities law violation. Such actions have contributed to great damage
being inflicted on shareholders, but the person aiding or abetting the
crime here in the United States knows the shareholder has no right to
sue them, unless the person aiding and abetting the crime tells the
public they are doing so. Such a ridiculous standard, which fails any
test of common sense, needs to be corrected. And as is discussed later
on, regulators often have not had the resources or the will to pursue
such cases.
The Act further enhances investor protections by giving the SEC
enforcement authority in key areas, and giving the SEC greater ability
to hold market participants accountable for violations of the law.
Under the Act, civil money penalties may now be imposed by the SEC in
cease and desist proceedings. This should serve as a further deterrence
to fraud. The SEC enforcement director has stated this will also
enhance the effectiveness and efficiency of the Division's enforcement
efforts, a view I agree with.
With the growing number of global markets, the legislation amends
the 1933 Securities Act and 1934 Exchange Act to give U.S. district
courts' jurisdiction over violations of the antifraud provisions when
there is conduct in the United States that furthers the fraud, even if
the securities transaction occurs outside the United States. Being able
to have redress in these situations is critical to investor confidence
and ability to invest safely. It is also important to ensure
accountability on the part of those who engage in such unlawful
behavior.
Dodd-Frank also requires the SEC to study the extraterritorial
application of the securities laws to actions that would be brought by
investors. This is in response to the U.S. Supreme Court ill advised
opinion in the case of Morrison v. National Australia Bank, Ltd. In
November, 2010, a number of public pensions, including one for which I
serve as a trustee, wrote this Committee urging them to reverse this
opinion. Investors must have an opportunity to obtain redress in the
U.S. courts for fraud committed in the United States by foreign
entities which seek capital from U.S. investors, and U.S. Federal
securities laws should deter fraudulent statements by foreign entities
to investors.
Improvements to the Management of the Securities and Exchange
Commission--Sections 961, 962 963, 964, 966, 967, and 968
Leading up to and during the subprime financial crisis, the SEC has
been the subject of much public criticism of its management. Most
notably have been complaints for its failure to investigate
whistleblower complaints on Madoff and the Stanford Group, a failure to
adequately supervise market participants such as Bear Stearns, Lehman
and Merrill Lynch, questionable investigations such as in the Aguirre
matter, the leasing matter that has now been referred to the Department
of Justice by the Inspector General, poor internal controls and lax
enforcement actions such as the one against Bank of America which the
judge was extremely critical of. I can't help but believe some of these
criticisms are the result of very poor leadership and management of the
agency during the later half of the past decade. Leadership that, in my
opinion, failed to foster the right tone at the top, culture and
investor advocate mission that had long been the mantra of a proud
agency and its staff.
In the past, the SEC has had a reputation as the gold standard
among regulators. But that image has been tarnished by the criticisms
noted. Yet a well managed and run, independent SEC is vitally important
to the capital markets. Investors over the years have had confidence in
the markets, firmly believing the SEC ensured confidence could be
placed in financial disclosures, that the markets were fair and the
playing field level. I can tell you from personal experience, many an
employee of the SEC has taken great pride in providing outstanding
public service and their efforts to ensure the agency was indeed the
public watchdog, the one true investors advocate.
There are a number of provisions in Dodd-Frank that I believe, as a
former business executive, will contribute in a positive manner to the
SEC restoring public confidence in the agency. I have found one manages
what one measures, and does not manage what one does not measure. While
the SEC has required public companies to increase their transparency,
controls, monitoring and accountability, it has fallen short of
adopting some of its own recommendations in a timely manner that could
have been beneficial, such as reporting on internal controls.
Accordingly, enhancements to the SEC's management and structure that
will in the long run benefit it, include:
An assessment of its overall structure and personnel;
Enhanced monitoring, assessment and transparency of
supervisory controls;
Greater accountability for supervision through
certification of the effectiveness of controls;
Increased evaluation, monitoring and transparency of
personnel management including actions taken with respect to
those who have failed to perform their duties;
A suggestion program and hotline for the employees of the
agency; and
Taking a long hard look at its ``revolving door.''
Unfortunately, the study mandated by Dodd-Frank only requires a
study of employees leaving the SEC for financial institutions
and not the largest and fastest spinning revolving door--
employees who leave the SEC bound for legal firms that
represent individuals and public companies before the SEC.
Securities and Exchange Commission Funding--Section 991
The SEC has sought now for over two decades, the same types of
self-funding mechanisms that banking regulators have. Unfortunately,
Senate conferees rejected such a provision, which in June, 2010, the
Federal Bar Associations securities law committee stated was
``critical'' to the ``chronic underfunding'' of the SEC.
Current and former SEC Chairmen such as Arthur Levitt and Richard
Breeden have urged Congress to increase the SEC's funding so that it
can do the job Congress and investors expect of it. Those who represent
investors such as the Council of Institutional Investors have also
called for increased funding of the SEC. Investors have always voiced
support for adequate funding of the SEC and ultimately, the money comes
out of their pockets.
As the GAO has noted in prior reports, the SEC was essentially
starved by Congress of necessary resources during much of the 1990s.
During this time period the markets experienced fast growth as millions
of Americans invested through their retirement accounts. After this
underfunding contributed to and played a role in the corporate scandals
of a decade ago, Congress increased the funding of the agency. But
during the period from 2005 to 2007, as the subprime market bubble was
growing toward an implosion, the SEC staff was again reduced by over 10
percent and its spending reduced by some $75 million as a result of
actions by Congress and management of the agency.
Despite the fact no taxpayer dollars are used to fund the SEC, but
rather it is funded through user-based fees, it seems as if Congress
has been bent and determined to somehow shrink the SEC to greatness.
The fact of the matter is that congressional approach at times over the
past two decades has been an absolute miserable failure.
Congress through Dodd-Frank, as well as the public has upped the
bar for performance by the SEC and rightly so. The SEC is being asked
to increase its inspections, its enforcement, the number of entities
and the types of transactions it regulates. Dodd-Frank also requires
the SEC to establish several new offices such as the office of the
Investor Advocate and Ombudsman, the Office of Credit Ratings and the
Whistle Blower office. I believe investors in general are strong
proponents of these new functions at the SEC. At the same time, the SEC
is being asked to do a much better job of market surveillance and take
proactive steps to identify and address in a timely manner future
market problems, before they become a crisis. To accomplish all of
these tasks takes top notch people with the requisite experience, and
very significant investment in technology, training and support
services. And that takes money.
Dodd-Frank specified acceptable levels of funding, which have been
applauded by many investors. Those levels are as follows:
2011--$1.3 billion
2012--$1.5 billion
2013--$1.75 billion
2014--$2 billion
2015--$2.25 billion
Unfortunately, Congress is already breaking its promise to
investors and the SEC for the year 2011 as its funding is below the
$1.3 billion level. If such funding is not forthcoming, and there are
further crisis in the capital markets, such as has been seen with the
flash crash, a good deal of the blame will rest squarely on the
shoulders of Members of Congress.
Expansion of Audit Information to Be Produced and Sharing Privileged
Information with Other Agencies--Section 929, and 929 K
The Act expands the power of the Public Company Accounting
Oversight Board (``PCAOB'') by:
1. Broadening the PCAOB's authority to include independent audits of
broker dealers;
2. Enhancing the PCAOB's access to work papers of foreign auditors;
and
3. Share information with foreign regulators.
The Madoff ponzi scheme brought to light a gaping hole in the
regulation of independent audits investors rely upon. The PCAOB did not
have the authority to inspect the audit of the Madoff fund, and the
auditor was not subject to inspection by the accounting professions
peer review program. To this day, the Madoff auditor would not be
subject to inspection by the State regulator as he was a sole
practitioner. Dodd-Frank rightly remedies this shortcoming by giving
the PCAOB the right to inspect such audits and ensure the firms
providing such audits have effective systems of quality controls.
More recently, scandals resulting from flawed audits of Chinese
companies have also come to light, resulting in large losses for
investors. Much of the audit work has been performed by Chinese
auditors, although a U.S. audit firm may issue the audit report read
and relied upon by investors. At the same time, with U.S. companies
increasing their global operations, a growing portion of their audits
are performed by foreign audit firms, many of which are affiliated with
U.S. audit firms. If the PCAOB is to carry out its mandate of providing
investor protections, it must be able to inspect the auditor work, and
documentation of that work, regardless of where it is performed.
For example, frauds at such companies such as Satyam, Enron, Xerox,
and the now infamous Lehman Repo 103 transactions involved transactions
and related audit work executed in foreign countries. Without the
access to audit work papers for this audit work, the PCAOB cannot
ensure that the work supports the overall opinion the auditors are
providing on the consolidated financial statements of the company. Nor
can they inspect audit quality for a significant portion of the audit,
leaving investors exposed to a portion of an audit where quality may be
substandard at best.
Ensuring international audit quality, especially with respect to
large international conglomerates that can attract hundreds of billions
in capital from investors, is critical to confidence in financial
disclosures that are the life blood of any capital market. It is
important the PCAOB be able to share information, work and cooperate
with its counterparts in carrying out this mandate. But I have talked
to foreign regulators who expressed criticisms of the PCAOB, and a
reluctance to work with it. That was because while they could share
information with the PCAOB, it was a one way street because the prior
law prevented the PCAOB from sharing information with them. The prior
law had been adopted when the PCAOB was new and its counterparts in
foreign jurisdictions did not exist. But that has changed and once
again, to its credit, Dodd-Frank has updated the law and corrected this
deficiency. It did so by giving the PCAOB the ability to share
information with foreign regulators on a confidential basis. This was a
badly needed reform to ensure regulatory cooperation on an
international basis.
At the same time, the PCAOB has also called upon Congress to allow
it to enhance the transparency of its enforcement program. It would do
so by making its enforcement actions public, at an appropriate time,
consistent with the way the SEC handles its 102(e) enforcement actions.
Having been involved with the development of the current SEC 102(e)
rule, I applaud the PCOAB for working to enhance its transparency.
Without such a rule change, as evidence is now starting to show, audit
firms will take every action available to them to seriously delay
enforcement actions, during which time they continue to issue audit
reports while their quality controls and audit work may suffer from
serious deficiencies. This exposes investors and the capital markets to
great risks which lack any transparency whatsoever.
Other Sections
There are many other important sections of Title IX of the Act
which I also strongly support. The governance provisions granting
investors the same access to the proxy for nominating directors as
management has, is a great tool for establishing accountability over
entrenched and underperforming boards. Creating independent
compensation committees, enhancing the transparency of compensation and
incentives, and giving shareholders an advisory vote on pay should all
prove to be beneficial to ensure destructive risks taking is not
rewarded, and executives compensation is based on performance. Already
investors have shown they can use such rights in a wise and reasoned
manner. And while investors did not get all that they wanted in this
section of the bill, it was a very positive step forward.
The enhanced regulations of credit rating agencies should also
improve the quality of credit ratings. Especially important is the
private right of action granted investors, a useful mechanism to hold
credit rating agencies accountable.
Closing
I believe the sections of Dodd-Frank I have discussed all help
build and contribute to a stronger foundation upon which the capital
markets can function more effectively. They increase transparency and
accountability, they enhance independence including that of the
regulator, they will improve the effectiveness of the SEC and PCAOB,
and they certainly give these agencies greater authority necessary to
enforce the laws and protect investors. That in turn should give a
boost to investors confidence in the markets which is necessary if the
capital markets are to continue to be the crown jewel of our economy.
Thank you and I would be happy to take any questions.
RESPONSE TO WRITTEN QUESTIONS OF SENATOR MORAN FROM DAVID
MASSEY
Q.1. Mr. Massey, as you know Section 410 of the Dodd-Frank Act
will shift between 3,000 and 4,000 registered investment
advisors from SEC regulation to State regulation. However, this
shift is coming at a time when States are struggling with major
budget deficits and dwindling resources. How can we be certain
that State regulators will have the resources necessary to
properly regulate investment advisors and protect investors?
How will States meet this challenge and increase their
examination and regulatory resources?
A.1. Senator, the States have been presented with a unique
regulatory challenge--an increase of approximately 25 percent
in the number of investment advisers subject to State
regulation that will result from the increase in the assets-
under-management threshold from $25 million to $100 million,
mandated under Section 410 of the Dodd-Frank Act (``Act'').
Fortunately, the States and the North American Securities
Administrators Association (``NASAA'') have been preparing to
meet the challenge of regulating an additional 3,200 investment
advisers for over a year, and I am confident that these
preparations will permit State regulators to implement
intelligent, efficient and responsive regulation.
As I testified during the Senate Banking Committee hearing
of July 12, the States have a proven track record in the area
of investment adviser regulation. Further, NASAA is confident
that State securities regulators will continue to marshal the
examination and enforcement resources necessary to effectively
regulate the investment adviser population subject to their
oversight. While State investment adviser examination programs
and resources are documented in significant detail in the
comprehensive report that NASAA provided the Securities and
Exchange Commission in support of the Act's Section 913
study,\1\ some significant findings from that report include:
---------------------------------------------------------------------------
\1\ Available at http://www.sec.gov/comments/4-606/4606-2789.pdf.
LStates employ more than 400 experienced employees
dedicated to the licensing and examination function,
including field examiners, auditors, accountants, and
attorneys. More than half of the States that reported
qualitative staffing data indicate an average staff
experience exceeding 10 years, with a heavy
---------------------------------------------------------------------------
concentration of personnel in the 5- to 14-year range.
LState investment adviser examination totals have
progressively increased each year for the past 5 years,
resulting in a 20 percent increase in the total number
performed through the first three quarters of 2010 as
compared to 2006. As of August 2010, States had
completed 2,463 onsite examinations of investment
adviser registrants.
LThe majority of State routine (non-cause)
investment adviser examinations are performed on a
formal cyclical basis. All States that adhere to a
formal cycle audit their entire investment adviser
registrant populations in 6 years or less. Half of the
States complete the examinations on 3-year-or-less
cycles.
Memorandum of Understanding (MOU) for the Sharing of Resources
Even a highly skilled workforce cannot succeed absent
adequate resources, and the need for additional resources is a
natural consequence of additional responsibility. To that end,
the 50 States have agreed through a formal MOU to work together
and share resources as needed to regulate the expanded State
investment adviser population. Pursuant to this MOU, all States
will work to ensure that examination resources are augmented,
and that schedules are coordinated, to allow for maximum
coverage and consistent audits. The MOU also provides for the
possibility of joint exams funded by NASAA. The MOU will bridge
the gap while and until State regulators acquire any necessary
additional resources.
Frequency of Examinations
In recent years, the States have undertaken to increase the
frequency of investment adviser examinations. In 2006, States
reported 2,054 examinations of investment advisers, while in
2007 and 2008 that number increased to 2,136 and 2,389
examinations respectively. In 2009, State regulators performed
2,378 onsite examinations of investment advisers, not including
the countless number of regular-desk, registration, and other
abbreviated examinations that States perform every day. As of
August, 2010, the States had performed 2,463 investment adviser
audits, putting them on pace to again increase the total number
of investment adviser examinations relative to the previous
year. This trend constitutes a material and progressive
increase, year over year, for five consecutive years.
The States stand ready and able to take on these new
examination duties, and State securities administrators have
been proactive in their preparation, as outlined below.
Development of Uniform Exam Procedures
Another important step that the States have recently
undertaken to prepare for the switch-over has been to develop
uniform examination procedures. These new procedures will
promote and guarantee a consistent and high standard of
examination at the State level, effectively ensuring that all
State examinations--whether conducted in North Carolina, North
Dakota, or Kansas--ask the same questions of investment
advisers.
Utilization of New Risk Analysis Tools
NASAA has invested in new tools that will permit States to
continue to do an even better job of leveraging their resources
in the examination of investment advisers. Specifically, NASAA
has acquired advanced risk-analysis software and has made this
software available to all State regulators. The software will
provide States a mechanism to rapidly review their investment
adviser registrants, and rank the individual risk factors
associated with each registrant. This tool will evolve as time
goes on, but the bottom line is that the new software will
permit States to better evaluate the risks associated with
various firms and allocate their examination resources
accordingly.
Industry Outreach Campaign
NASAA members have in the past year initiated an aggressive
industry outreach campaign to prepare the industry for State
oversight and to enable new registrants to set up their
operations properly in order to avoid inadvertent
noncompliance. The goal of this outreach campaign is to bring
the legitimate investment advisers, the State regulators, and
NASAA together, prior to the switch-over, so that all parties
can establish a positive and constructive working relationship.
By facilitating a partnership among the States and the many
investment advisers who conduct their businesses in a
legitimate and professional manner, this initiative will
maximize the time and resources that State regulators can
devote to protecting investors.
Senator, I would be pleased to answer any additional
questions you may have.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM LYNNETTE
HOTCHKISS
Q.1. Ms. Hotchkiss, the Board through the EMMA Web site makes a
large amount of municipal bond market information freely and
instantly available to investors. Do you feel that the
availability and use of EMMA impacted the stability of the
municipal market during the recent financial crisis and, if so,
how? Does the Wall Street Reform Act impact the ability to
operate and expand EMMA?
A.1. Of course it's impossible to know the precise effect that
EMMA may have had in helping the municipal market weather the
financial crisis, but I do know that it has had a considerable
impact in raising the level of confidence in the municipal
marketplace and giving all market participants equal access to
the critical information needed to make informed investment
decisions. EMMA came just when it was most needed, as the full
impact was being felt of the municipal bond insurance
downgrades resulting from the spreading financial devastation
of the mortgage-backed securities collapse. We launched EMMA as
a pilot disclosure utility in March 2008, for the first time
making the full library of basic bond offering documents for
most outstanding municipal securities issued since 1990, along
with real-time trading information, available for all market
participants at no cost. We have received highly complementary
feedback from many retail investors attesting to the value of
the information they find on EMMA and on their increased
confidence in investing in the municipal securities market as a
result of such availability.
As to the effect of the Dodd-Frank Act, we believe it was
important to have our information dissemination function
clearly delineated in our authorizing statute, and we look
forward to working with other regulatory organizations in
creating cross-market information systems as contemplated under
Dodd-Frank. The ability to fully fund future enhancements to
EMMA and to ensure secure and reliable operations of the system
are the biggest barriers we see to realizing EMMA's full
potential. Given that the information available through EMMA is
a significant benefit to all market participants, we believe it
is crucial that funding for the system be as broad-based as
possible. We believe that Dodd-Frank struck the delicate--and
right--balance of preserving free public access to EMMA's core
collection while providing the MSRB with the ability to provide
for the financial viability of our information systems through
commercially reasonable fees for subscription or similar
services as well as for customized data and document products
and services. So long as we maintain the free core collection
through EMMA, we think it is crucial for the health of the
system and the benefit of marketplace that our ability to
charge such commercially reasonable fees not be read too
restrictively.
Q.2. Section 975(c)(8) of the new law created Section
15B(c)(9)(A) of the Exchange Act, which states that ``Fines
collected by the Commission for violations of the rules of the
Board shall be equally divided between the Commission and the
Board'' and
Fines collected by a registered securities association under
section 15A(7) with respect to violations of the rules of the
Board shall be accounted for such registered securities
association separately from other fines collected under section
15A(7) and shall be allocated between such registered
securities association and the Board, and such allocation shall
require the registered securities association to pay the Board
\1/3\ of all fines collected by the registered securities
association reasonably allocable to violations of the rules of
the Board, or such other portion of such fines as may be
directed by the Commission upon agreement between the
registered securities association and the Board.
Have fines subject to this provision been collected thus
far? If so, how have these fines been allocated? Please
describe how this process will work going forward.
A.2. With respect to fine collections by a registered
securities association--which means the Financial Industry
Regulatory Authority, or FINRA--our two organizations have
worked through an initial process for allocating fines and the
MSRB began receiving monthly remittances earlier this year. The
current allocation is based on the \1/3\ apportionment formula
set out in the statute and our two organizations continue to
review how that apportionment is applied in situations where a
broker-dealer may have violated both MSRB and FINRA rules, and
we will make any adjustments that may be necessary if we find
that some situations call for a different manner of application
on overlapping violations. We are in the final stages of
memorializing the allocation in a memorandum of understanding
between our two organizations.
As of now, the Commission has not yet collected any fines
since October 1, 2010, that it has attributed to a violation of
MSRB rules, but we expect that the Commission will be stepping
up its enforcement activities with respect to MSRB rules,
particularly in light of the additional areas of MSRB
rulemaking and the broader scope of the protections of those
rules called for under the Dodd-Frank Act. One complicating
factor that has delayed our establishment of a precise
allocation process is that most fines levied by the Commission
are paid directly to the U.S. Treasury, which could result in
significant complications in having the MSRB allocable portion
paid to us. It is our understanding that the Commission is
considering providing for a separate levy of the MSRB allocable
portion on any broker, dealer, municipal securities dealer or
municipal advisor found to be in violation of MSRB rules, with
payment of the MSRB allocable portion mandated under the Dodd-
Frank Act to be made directly from such entity to the MSRB. We
hope that the Commission is able to come to resolution on this
process in the very near future so that we can proceed to
document this allocation process.
Q.3. Earlier this month, the U.S. Securities and Exchange
Commission (SEC) charged a division of JPMorgan Chase with
fraud in connection with rigging of 93 municipal bond
transactions in 31 States. What proactive steps has the MSRB
taken to address conduct similar to that uncovered by the SEC?
A.3. The MSRB has been extremely active in undertaking
rulemaking that covers the behavior of bond underwriters and
municipal advisors to issuers in connection with questionable
or illegal activities such as bid rigging. We proposed in
February and are nearing the completion of the rulemaking
process on guidance under both our general fair practice rule,
Rule G-17, and a new Rule G-36, implementing the new Federal
fiduciary duty of municipal advisors under the Dodd-Frank Act,
that would squarely prohibit the key wrongful actions
undertaken in this case. For example, under the Dodd-Frank Act,
``municipal advisor'' was defined to include guaranteed
investment contract brokers, or GIC brokers, who now have a
Federal fiduciary duty to the issuer. The MSRB guidance on
fiduciary duty would prohibit receipt of payments from other
parties in return for giving favorable treatment in what is
supposed to be a competitive bidding process, even if they
disclosed such payments. In addition, the proposed MSRB fair
practice guidance for underwriters would establish significant
new disclosure obligations to issuers, including specifically
disclosures on conflicts of interest. That guidance would
require that underwriters not charge excessive compensation. In
determining whether compensation is excessive, underwriters
would have to include payments from third parties, such as
payments from swap providers or GIC brokers paid to the
underwriters for recommending those parties to the municipal
issuer.
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RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM BARBARA
ROPER
Q.1. In your written testimony, you state that credit rating
agencies should be held to the same accountability standards
faced by auditors and underwriters. Could you go into a little
more detail about what you mean by this? What are the strengths
and weaknesses of this approach? How should the SEC address the
current state of relief (no-action letters) to issuers that do
not disclose ratings in their prospectuses?
A.1. Much like auditors, credit rating agencies operate as
private gatekeepers in our financial system. In fact, much as
our system of financial disclosure rests on the assumption that
auditors can provide reasonable assurance of the accuracy of
those disclosures, the entire system of regulation for the
securitization process was built on the assumption that ratings
could reliably assess the risks associated with these
investments.
LThe special purpose vehicles that purchase the
assets and issue the asset-backed securities (ABS) were
exempted from the Investment Company Act based on
credit ratings.
LABS, including mortgage-backed securities (MBS),
qualified for sale through shelf registration based on
credit ratings.
LUnder the Secondary Mortgage Market Enhancement
Act, MBS that received ratings in one of the two
highest categories were deemed acceptable investments
for Federal savings and loan associations and credit
unions and for State-regulated entities, such as
insurance companies, unless the State opted out.
LOther Federal and State regulators of financial
institutions counted asset-backed securities that
received top ratings from an NRSRO at face value toward
minimum capital requirements.
Just as auditors' failure to serve as effective gatekeepers
was a key contributing cause of massive accounting scandals a
decade ago, the rating agencies' failure to serve that
gatekeeper function effectively was a key contributing cause of
the 2008 financial crisis.
One way Dodd-Frank deals with that failure is by
eliminating regulatory references to ratings. While this is an
appropriate step, in our view, the regulators have struggled to
find a way to implement it without inadvertently introducing
new risks into the financial system. Even the harshest rating
agency critics have failed to identify alternative measures of
creditworthiness to serve as effective substitutes for credit
ratings. As a result, for better or worse, credit rating
agencies are likely to continue to play an important role in
the financial system as arbiters of credit risk. Their
gatekeeper function, while diminished, is therefore expected to
continue. The clear implication is that it is not enough simply
to reduce regulatory reliance on ratings, it is also essential
to take steps to increase rating agency reliability.
In seeking an explanation for the rating agencies' failure
to perform as effective gatekeepers, it quickly becomes
apparent that they lack two of the most important
characteristics we look for in a gatekeeper: independence and
accountability. Their lack of independence is well documented
in the recent bipartisan report on the causes of the financial
crisis by the Senate Permanent Subcommittee on Investigations.
With voluminous evidence taken from internal emails and witness
testimony, the report shows rating agencies well aware of
growing risks in the housing market but reluctant to reflect
those risks in their ratings out of concern that it would cost
them market share. In short, the major rating agencies
prioritized profits over rating accuracy, and nearly brought
down the financial system in the process.
The fundamental conflict at the heart of the credit rating
agencies' issuer-pays business model creates a strong incentive
for rating agencies to under-invest in analysis, to assign
ratings even where the credit risks are unknown, and to inflate
ratings in order to protect their market share and maximize
profits. In the past, they have faced no comparable
countervailing pressure to promote rating accuracy. Given the
scale of the conflict, we share the view expressed by Columbia
University law professor John Coffee in March 10, 2009
testimony before this Committee, that, ``The only force that
can feasibly induce'' credit rating agencies to perform the
kind of independent verification and analysis demanded of
gatekeepers ``is the threat of securities law liability.''
While enhanced regulatory oversight can help, past experience
suggests that the SEC is likely to be too timid in exerting its
authority to serve as an effective deterrent, particularly if
Congress fails to come through with the increased funding the
agency needs to implement the law effectively.
In order to strike the right balance, credit ratings should
be liable not simply for getting it wrong but rather when they
show a reckless disregard for the accuracy of their ratings. As
noted above, the Permanent Subcommittee on Investigations
Report is full of examples of these sorts of abuses, as is the
early study by the staff of the Securities and Exchange
Commission. That is the balance struck in Dodd-Frank, which
establishes recklessness as the standard of proof in private
actions. It remains to be seen, however, whether courts will
accept that approach, or will continue to view ratings as
protected by the First Amendment, even where the ``opinion'' in
question does not reflect the actual views of the rating
analyst of credit risk. If courts do begin to hold rating
agencies liable, it should make the rating agencies less likely
to assign ratings to securities (such as CDOs-squared) whose
risks they do not understand and cannot calculate. Likewise, it
should make them less willing to override their rating criteria
to assign inflated ratings or to delay updating their rating
criteria to reflect emerging risks out of a concern that it
could cost them business.
The SEC no action position with regard to issuers who do
not disclose ratings in their prospectuses raises a somewhat
different set of issues. In keeping with its goal of reducing
reliance on ratings, Dodd-Frank eliminated the special
exemption from expert liability that was granted to rating
agencies specifically to encourage the use of their ratings in
prospectuses. When the provision took effect, however, the
major rating agencies threatened to shut down the still fragile
securitization market by refusing to allow their ratings to be
published in prospectuses. Under pressure to revive
securitization, the SEC issued a no action letter, later
indefinitely extended, permitting issuers to forego disclosing
ratings in the prospectus. Because of the separate Dodd-Frank
provisions requiring financial regulators to eliminate all
regulatory references to credit ratings, the requirement to
disclose ratings was presumably on its way out anyway.
Under the circumstances, we did not come out in strong
opposition to the SEC action, despite our support for making
ratings agencies legally accountable for their actions. Once
the regulatory requirement to disclose ratings in the
prospectus is eliminated, however, the Commission should
rescind its no action letter so that only the ratings of
ratings agencies willing to stand behind their work would be
disclosed in prospectuses. Under no circumstances should the
special exemption from liability be reinstated. To do so would
encourage reliance on ratings by encouraging their inclusion in
prospectuses and would do so without subjecting them to
appropriate legal accountability when they show reckless
disregard for the accuracy of their ratings.
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RESPONSE TO WRITTEN QUESTIONS OF SENATOR MENENDEZ FROM BARBARA
ROPER
Q.1. A provision that I successfully included in Dodd-Frank
would require publicly listed companies to disclose in their
SEC filings the amount of CEO pay, the typical workers' pay at
that company and the ratio of the two. The past few decades,
CEO pay has skyrocketed while the median family income has
actually gone down. The House Financial Services Committee
voted to repeal the provision last week under the guise of two
arguments, first that it was ``too burdensome'' for companies
to disclose that and second, that the information wasn't useful
to investors.
I believe the real reason some companies don't want to
reveal it is because they would find it embarrassing to reveal
that they pay their CEO say 400 times what they pay their
typical employee. And I find it very hard to believe that
companies that do all kinds of complicated calculations for
everything else involving their revenues and expenses would
find it difficult to take their 2,000 employees, figure out how
much employee number 1,000 is paid, and report that one number
to the SEC. It seems to me that a company that can't manage to
do that needs a new H.R. Department.
Do you believe such information would be useful to
investors? These same investors are now often voting on an
annual basis in say-on-pay votes. Would it be useful for them
for example to know that in the past few years, a company has
increased its CEO's pay by 50 percent while decreasing its
typical worker's pay by 10 percent? Would it help investors to
determine what a company's philosophy is, such as whether it is
following Peter Drucker's theory that there should not be huge
pay disparities between the executives and the typical worker
for morale, inherent fairness, or other reasons?
A.1. Investors have an interest in CEO pay disclosures for a
variety of reasons. First, excessive CEO compensation comes at
the expense of shareholders of publicly traded companies.
Second, excessive compensation may encourage executives to take
undue risks. Ironically, existing compensation disclosures have
been criticized for inadvertently promoting excessive
compensation by encouraging competition among executives for
more generous pay packages. In addition, while they provide a
certain amount of data, existing disclosures fail to put that
data in context. One of the best measures of executive
compensation that is out of line can be found by comparing it
to the pay of average workers, as your provision would require.
Where CEO compensation is many times higher than that of the
average worker, investors may reasonably conclude that the
company is being run for the benefit of executives rather than
for the benefit of shareholders. That may affect how they vote,
not only on say-on-pay votes, but also how they vote in
director elections. That may help to encourage compensation
committees to be more responsible when doling out CEO pay. The
required disclosures also provide information about typical
employee compensation packages, information investors are
likely to find relevant in light of the fact that compensation
is the biggest single expense at many public companies. For all
these reasons, we oppose efforts to repeal the enhanced CEO
compensation disclosures provided by Dodd-Frank.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR SHELBY FROM ANNE
SIMPSON
Q.1. Section 953 of Dodd-Frank requires companies to disclose
the ratio between the compensation of the chief executive
officer and that of the median employee. Are you aware of any
evidence that links relative pay ratios to corporate
performance? Is this ratio material for making investment
decisions?
A.1. We are unaware of any research on this specific topic.
However, this should not come as a surprise since issuers do
not presently disclose these ratios. As far as whether an
investor would find this information material, it probably
depends on the investor. Similar to disclosures by an issuer's
highest paid executives, the ratio between a company's CEO and
a typical employee would be yet another metric for measuring
assessing the reasonableness of executive compensation in the
context of the company's performance.
Q.2. In your testimony, you observed that a ``a common element
in the failure of . . . many . . . companies implicated in the
2008 financial meltdown, was that their boards of directors did
not control excessive risk taking, did not prevent compensation
systems from encouraging a `bet the ranch' mentality, and did
not hold management sufficiently accountable.'' A recent
European Corporate Governance Institute paper reported that
financial firms with more independent boards and higher
institutional ownership suffered larger losses during the
crisis period and that these losses were related to executive
compensation contracts that focused too much on short-term
results. Why do institutional investors such as CALPERS endorse
executive compensation contracts that focus on short-term
results and encourage aggressive risk-taking?
A.2. Institutional investors such as CALPERS do NOT endorse
executive compensation contracts that focus on short-term
results and encourage aggressive risk-taking and we reject the
conclusion in the referenced working paper. The fatal flaw of
the paper is that it includes exactly one corporate governance
factor--board independence. Although the independence of the
board of directors is a key governance consideration, it is
certainly not the only consideration. See CalPERS Principles of
Accountable Corporate Governance (http://www.calpers-
governance.org/docs-sof/principles/2010-5-2-global-principles-
of-accountable-corp-gov.pdf. I also would refer you to an
October 2010 report by Wilshire Associates (http://www.calpers-
governance.org/docs-sof/principles/2010-5-2-global-principles-
of-accountable-corp-gov.pdf) which concluded that engagement by
institutional investors with corporate boards/management has
resulted in long-term performance superior to market
benchmarks.
------
RESPONSE TO WRITTEN QUESTIONS OF SENATOR HAGAN FROM ANNE
SIMPSON
Q.1. Many witnesses addressed the fact that the Department of
Labor (``DOL'') recently proposed regulations under ERISA that
would redefine the term ``fiduciary''. Many Members of the
Committee have expressed concerns about the coordination that
is taking place between the DOL and SEC.
As an investor at a large pension system, do you have
concerns about the DOL's changes or concerns about the
interaction that is taking place between the DOL and other
agencies on this issue?
A.1. As a Government-sponsored plan, CalPERS is not governed by
ERISA. Instead, CalPERS is regulated by State law. As such,
CalPERS has no opinion as to DOL's definition of fiduciary
duty.
Q.2. In your testimony you stated that ``a tough clawback
policy is an essential element of a meaningful pay for
performance philosophy.'' It is my understanding that, in
addition to internally managed equity investments, many State
retirement systems such as CaIPERs, may allocate to external
alternative investment managers.
Does your support for ``tough clawbacks'' extend to
compensation arrangements with external managers?
A.2. Compensation arrangements between a corporation and its
executives are quite different than those between an
Institutional investor and its external money managers.
However, in the spirit of protecting long-term shareowner
value, CalPERS supports the notion of accountability by both
corporate executives and its external money managers.
Accountability for money managers comes in the form of
agreements whereby contractual rights and obligations are
imparted upon each party. Fortunately, CalPERS has not needed
to seek judicial redress with any external manager.
Q.3. Is it common for pension funds to negotiate compensation
arrangements with external managers that contain performance
clawbacks as way deter managers from prioritizing short-term
gains over long-term alignment? If not, what have been the
hurdles?
A.3. CalPERS is unfamiliar with how other plans negotiation
money management agreements, so we are unable to opine on
whether a particular practice is common for public pension
funds. However, when we negotiate such agreements, we insist
that they include legal protections for the plan. We would
expect other prudent fiduciaries would demand similar
protections.
------
RESPONSE TO WRITTEN QUESTION OF CHAIRMAN JOHNSON FROM PAUL S.
ATKINS
Q.1. Mr. Atkins, in your testimony you stated that, ``Congress
should consistently push transparency and competition so that
investors get high-quality and objective advice from credit
rating agencies.''
Section 932 of the Dodd-Frank Act contains many provisions
that promote transparency for the benefit of investors,
including requirements that:
LNRSROs publish a form accompanying their ratings
that will include the assumptions underlying the credit
rating procedures and methodologies, the data that were
relied on to determine the credit rating, and any
problems or limitations with those data;
LNRSROs publish the initial credit ratings
determined for each type of obligor, security and money
market instrument, and any subsequent changes to such
credit ratings, for the purpose of allowing users of
credit ratings to evaluate the accuracy of ratings and
compare the performance of ratings by different NRSROs;
and
LNRSROs publicly disclose the reasons when they make
material changes to credit rating procedures and
methodologies, and notify users of credit ratings of
the version of a procedure or methodology used with
respect to a particularly credit rating, when a
material change is made to a procedure or methodology,
and when a significant error is identified in a
procedure or methodology that may result in credit
rating actions.
Subtitle D of Title IX of the Act contains new disclosure
requirements including Section 943, the requirement that each
NRSRO include in any report accompanying a credit rating a
description of the representations, warranties and enforcement
mechanism available to investors.
Do you feel that such transparency requirements could be
useful to investors?
A.1. Yes, Mr. Chairman, I agree that transparency requirements
for credit ratings can be useful to investors, especially if
they can help investors discern for themselves which ratings
deserve more credence. Ratings, after all, are professional
opinions, and the key to evaluating such an opinion is
understanding the qualifications of the person propounding the
opinion, the reasoning underlying the opinion, and any
influences that might affect the opinion one way or another.
But, we must recognize that any regulation can have unintended
consequences and should be subjected to a cost-benefit
analysis, since investors invariably pay for regulations one
way or another, through higher prices or reduced choices.
Because the credit-rating business has suffered from
concentration and lack of competition, largely due to a non-
transparent ``no-action'' process that the Commission permitted
to exist for three decades, which this Committee in 2006 wisely
prompted Congress to take strong steps to reform, the SEC must
be very careful to ensure that regulations in this area do not
further restrict competition or the ability of new entrants to
compete against the more established firms.
For example, the burden and costs of required disclosure
must be carefully weighed, as should the usefulness of the
required disclosure to investors. Ironically, the more
disclosure around ratings that make them seem more
authoritative, the more investors (especially retail investors)
may rely on them, discounting the fact that the ratings are
opinions at the end of the day.
In addition, the SEC should be careful to avoid influencing
the ratings themselves or consciously or inadvertently being a
judge as to supposed ``quality'' of ratings. Those sorts of
decisions are best left to the marketplace and investors
themselves. Finally, the SEC also must be careful, through
requirements that are one-size-fits-all, not to lead ratings
into the same general mold, reducing diversity of opinion. The
market thrives on diverse opinions--those who can warn of
anomalies that they perceive versus the ``group think'' of
consensus or conventional wisdom. Thus, in credit ratings,
standardization may not be necessarily helpful to investors,
although diversity of viewpoint is critical.
Additional Material Supplied for the Record
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