CAPITAL MARKETS ALERT: House Financial Services Capital Markets Subcommittee Hearing -- SEC Oversight: Current State and Agenda

    15 July 2009

    The following is a brief summary of today’s hearing in the House Financial Services Capital Markets Subcommittee hearing on the Securities and Exchange Commission (“SEC”).

    SEC Chairman Mary Schapiro was the sole panelist.

    I. Opening Statements

    Rep. Kanjorski (D-PA):

    • The Commission must continue to take bold and assertive action as it moves forward to bring enforcement actions against wrongdoers and to rewrite the rules governing the industry to better protect investors. Without further action to finalize regulatory proposals on proxy access, the custody of client assets, and short sale restrictions, investors will lack the real protections that they need. The hard work on these matters therefore lies ahead
    • We need new standards that reward whistleblowers when their tips lead to catching fraudsters. By encouraging whistleblowers to come forward when they know of wrongdoing, we will leverage the Commission’s limited resources and increase the number of cops on the beat.
    • Improving the Commission’s overall operation and performance will additionally require a significant increase in its budget. The House will soon consider a bill providing for a modest increase of 8 percent in the Commission’s 2010 budget. We must therefore seriously consider the Commission’s request to raise its 2011 budget authorization by an additional 20 percent.

    Rep. Garrett (R-NJ):

    • The area of regulatory proposals for Over-the-Counter derivatives is of key concern. 94% of the 500 largest global companies use derivatives to manage risk. Policymakers, therefore, need to tread very carefully as we look at regulatory options for these markets. Over-regulation or improper regulation that might sound good politically could have major unintended negative consequences, not just for our financial markets, but for our broader economy.
    • The Administration late last week released draft legislation seeking to establish consistent standards for broker-dealers and investment advisors that would also give the SEC the power to ban certain forms of compensation that are “not in the investors’ best interest.” This comes on the heels of the Democrats’ proposal for the so-called “consumer financial protection agency”. Both proposals reflect a government-knows best mentality that will likely restrict consumer choice and be embraced by trial lawyers for all the unnecessary litigation they will spawn.
    • I will be interested to hear from the Chairman regarding the SEC’s input on these proposals and to what extent she is comfortable dictating how a firm should compensate its employees.
    • I will be interested to hear an update on the SEC’s proposed rules to restrict short selling, as well as the Chairman’s thoughts on different ideas to reform credit rating agencies, which I know is an area that Chairman Kanjorski and others are interested in pursuing legislatively and may be one area of reform where some bipartisan consensus can be reached.

    Rep. Ackerman (D-NY):

    Constituents are not concerned with regulatory reform or other legislative issues, but rather how government agency failed in its oversight. Victims of Madoff want government to “live up to its word.” Seven months since fraud was revealed, and only 450 out of 15,000 victims have received insurance proceeds.

    Rep. Bachus (R-AL):

    Administration is heavy-handedly intervening in private affairs (economy and otherwise). Seems to be turning SEC into an IRS that will second guess business decisions. It has continued to miss the big problems in economy (ex.:Madoff).

    Rep. Capuano (D-MA):

    Supports SEC’s latest actions. Believes that the agency is going in the right direction.

    Rep. Royce (R-CA):

    SEC lack of experience/knowledge, investigative ineptitude must be addressed. Structural flaw in agency is heart of problem. Need to bring in more employees with market experience.

    Rep. Hinojosa (D-TX):

    Need to increase funding to SEC beyond Obama’s budget to ensure that agency can hire staff and increase salary level of employees to retain those with institutional knowledge.

    Rep. Hensarling (R-TX):

    Number of reservations about Administration’s plan.

    Rep. Klein (D-FL):

    With respect to new oversight regulation, a lot of common sense can go a long way. Need to retain and compensate those with valuable experience.

    Rep. McCarthy (R-CA):

    Looks forward to new restructuring of SEC to streamline agency’s efforts.

    Rep. Peters (D-MI):

    Concerned that companies no longer respond to shareholders. Wants to hear about SEC efforts to empower shareholders of executive compensation, director elections, and other steps needed from Congress to supplement SEC measures.

    II. Testimony of SEC Chairman Schapiro

    Singularly focused on rebuilding investor confidence in capital markets and agency.

    · Goals:

    • Fill regulatory gaps exposed by economic crisis;
    • Strengthen standards governing broker-dealers and investment advisers;
    • Enhance disclosure provided to investors;
    • Streamline enforcement procedures and focus on cases with greatest impact;
    • Revamp system for handling tips and complaints;
    • Improve risk assessment capabilities.

    Reinvigorating SEC Enforcement

    • Streamlining procedures within division; staff can enforce subpoena and issue corporate penalty without higher approval
    • Three times as many restraining orders compare to last year; 40 more opened investigations; tripled the number of temporary restraining orders and more than 100 more formal orders.
    • Significant efforts taken related to operators of Reserve Primary Fund who “broke the buck”, former NY Deputy Comptroller and others involved in kickback scheme, hedge fund insider trading case involving credit default swaps, securities fraud claims against former Countrywide CEO and ponzi scheme claims against Allen Stanford.

    Strengthening Examination Program and Oversight

    • Hiring more experienced staff who have the background in securities trading, portfolio management, valuation, forensic accounting, information security, derivatives and synthetic products, and risk management to conduct oversight of complex trading strategies and products and also enhancing training for staff.
    • Creation of newly-created Senior Specialized Examiner positions in the examination program or serving as fellows in the new Industry and Markets Fellows Program in our Office of Risk Assessment.

    · Improving Transparency & Investor Protection

    o Custody controls

    § New rules would protect investors’ assets by developing requirements for investment advisers and safeguards concerning custody. Proposals include annual “surprise exam” to verify assets exist or a requirement for examinations where assets are not held by a firm independent of the adviser.

    o Combating Short-Selling

    § In recent months, the Commission unanimously voted to propose two distinct approaches to short selling restrictions. One approach would impose a permanent, market-wide short sale price test, while the other would impose temporary short selling restrictions upon individual securities during periods of severe declines in the prices of those securities. The Commission held a public roundtable to solicit the views of investors, issuers, financial services firms, self-regulatory organizations and the academic community on key aspects of these proposals. The comment period to the proposal, which closed on June 19, resulted in over 3,700 comment letters. The Commission and staff currently are reviewing the comments in an effort to determine how to address this important issue.

    o Credit Ratings Process

    § In February, the Commission took a series of actions with the goal of enhancing the utility of NRSROs disclosures to investors, strengthening the integrity of the ratings process, and more effectively addressing the potential for conflicts of interest inherent in the ratings process for structured finance products. The requirements are designed to increase the transparency of the NRSROs’ rating methodologies, strengthen the NRSROs’ disclosure of ratings performance, prohibit the NRSROs from engaging in certain practices that create conflicts of interest, and enhance the NRSROs’ recordkeeping and reporting obligations to assist the Commission in performing its regulatory and oversight functions.

    § In conjunction with the adoption of these new measures, the Commission proposed an additional amendment which would require NRSROs to disclose ratings history information for 100% of all issuer-paid credit ratings. The Commission re-proposed an amendment that would prohibit an NRSRO from issuing a rating for a structured finance product paid for by the product’s issuer, sponsor, or underwriter unless the information about the product provided to the NRSRO is made available to other NRSROs.

    o Pay to Play

    § More needs to be done to curtail so-called “pay-to-play” practices by investment advisers to public pension plans. Investment advisers that seek to influence the award of public entities’ advisory contracts by, for example, making political contributions to officials able to influence the awards compromise their fiduciary obligations to the plans. Pay-to-play practices can distort the process by which investment advisers are selected and can harm advisers’ public pension plan clients, which may receive inferior advisory services and/or pay higher fees. In recent years, the SEC has brought several prominent actions charging investment advisers with participating in pay-to-play schemes, and criminal authorities have brought cases involving the same or similar conduct. The Commission has multiple on-going investigations of pay-to-play practices around the country.

    o Municipal Securities

    § The Commission will consider a recommendation to promote greater transparency and more-timely information being provided to municipal securities investors. Municipal securities investors would receive more information about events that affect investments and about variable rate demand obligations previously exempt from broker-dealer rules.


    III. Questions & Answers

    Kanjorski (D-PA):

    Q: Discuss how to improve regulatory activities within agencies?

    A: Must hold all members of agency responsible for their jobs; need honest assessment of failures of agency for Madoff and others. Currently engaged in review by Inspector General and also reviewing agency organization, lack of understanding, and experience in staffers to determine how to best allocate limited resources efficiently.

    Q: How does Obama Administration plan impact SEC’s jurisdiction?

    A: The non-merger of the SEC and CFTC means the two agencies must do a better job coordinating in the future, particularly as new investment vehicles are created that do not have a natural fit with either agency.

    Garrett (R-NJ):

    Q: How can the SEC prevent itself from reacting to the latest fraud and start preventing these events?

    A: All regulators play catch up, not just the SEC. To a certain extent, regulators will always be a step behind the fraudsters.

    Q: What role did the SEC have in the Obama Administration’s plan to put executive compensation rules in the Commission’s jurisdiction?

    A: The SEC has always been involved with executive compensation disclosure rules. The SEC sought the ability to regulate investment advisors and broker-dealers with respect to their fiduciary standards of care and weren’t able to do that previously because their compensation was outside the SEC’s authority.

    Rep. Ackerman (D-NY):

    Asked about where funds will come from to pay back investors losses from Madoff.

    Accountability – praised Schapiro.

    Rep. Bachus (R-AL):

    Asked about standardization of derivatives.

    A: Should have increased transparency, some central clearing, but need to let businesses hedge for protection in customized way. Must have incentives to move into standardized format, even without regulators. Envisioned that standardized product will have lower costs and requirements than for customized product.

    Q: How do you plan to increase supervision of credit rating agencies?

    A: Supervise the disclosure of conflicts and processes. Chairman is very interested in shopping done by issuers who seek possible ratings prior to selection. Possible that SEC would require all preliminary ratings sought and received; disclosure of underlying loan data to all other rating agencies to then create independent ratings to then have a comparison against the paid ratings. Commission is also trying to move away from ratings-based regulations.

    Rep. McCarthy (D-NY):

    Q: How is the SEC reforming itself after the recent troubles?

    A: The SEC is working primarily on investor protection and restoring investor confidence in the agency. An important part of that are the enforcement cases and making those efforts well known by the public. With respect to a new CFPA, the SEC should maintain enforcement, investor protection, securities laws and rulemaking.

    Rep. Royce (R-CA):

    Q: Repeated previous testimony by Markopolis (SEC investigator who was calling on monitoring of Madoff: would replace senior staff, then change the lowest level employees lacking experience. Then need whistleblower office to centralize complaints and be sure they are offered by regional offices.

    A: SEC has asked Congress for whistleblower statutes to give them additional funds/authorization. SEC received between 700,000 and 1 million tips per year and the agency cannot handle that number of tips as currently constituted.

    Q: Asked to comment on idea that the SEC is “overlawyered.”

    A: The SEC had a dedicated, hardworking staff. It is currently aggressively recruiting analysts with background in trading, valuation, risk management.

    Rep. Lynch (D-MA):

    Q: What are you doing to help staff make financial based analysis rather than legal analysis?

    A: The SEC is currently recruiting within examination program with particular skill sets (valuation, risk management, derivatives, etc.). Also have Office of Risk Assessment with a fellowship program to train other employees and help build capabilities to do most to evaluate the market.

    Q: Regulatory reform has suggested a standardized exchange for standard derivatives and also for customized private derivatives exchange. How is the SEC equipped to deal with the bifurcation of derivatives?

    A: Custom derivatives will need transparency and regulation of the related dealers in those transactions. The SEC and the CFTC will need to work closely together.

    Rep. Biggert (R-IL):

    Q: What is your opinion of new derivatives tax in cap/trade bill?

    A: Chairman is not familiar with this specific bill to give an opinion.

    Q: Are there any other big problems facing the SEC?

    A: There is a severe need to build technology into the framework of the agency that will allow it to keep up with cutting edge financial firms.

    Q: Last year, there was an temporary ban on short selling and when relaxed, Chairman Cox said the costs outweighed the benefits – why does the SEC now think restriction is good idea?

    A: Cox banned shortselling outright; which resulted in lower liquidity. The proposed current restriction is whether reinstatement of uptick rule should be reconsidered which doesn’t stop shortselling but stops shortselling when previous sale is at higher price. Considering comments received in determining next steps. Hope to have proposal by end of summer.

    Rep. Speier (D-CA):

    Comment: Need to give you more resources.

    Comment: Attorneys shouldn’t be able to leave SEC to work for company (revolving door).

    A: Similar problem for all agencies. Too many limitations will preclude them from joining SEC in first place. Need to find solution.

    Q: Rating agencies. Should be higher responsibility and/or liability for RA?

    A: SEC recently required new disclosure re: RA diligence procedures. RE: liability, could have important impact on RA actions.

    Rep. Castle (R-DE):

    Q: Asked about shareholders and the tension between them and the custodians/fund managers who hold the stock for their clients.

    A: At the end of the day, shareholders own the company and should be able to make decisions related to executive compensation and other issues before a board of directors. This interest must be balanced to encourage long-term prospective on investments and corporate activity.

    Rep. Adler (D-NJ):

    Q: How would respond to the claim that the SEC is good at nitpicking and finding minor errors, but missing the big problems?

    A: SEC has been good at its job in many different areas, but that the SEC is going to defer to state regulators where applicable, and work to stop bigger investor threats quicker than previously done.

    Schapiro: Imposing liability in RA would be a positive check on their performance. They need to better align with the investing public’s interests rather than the issuer’s interests.

    Rep. Hensarling (R-TX):

    Q: Could CFPA erode the investor protection mission of SEC?

    A: Transfer of enforcement to CFPA would take away from SEC’s ability to protect investors. Consequences for investors would be rulemaking function as response to enforcement cases would be weakened. CFPA overlap would be with hybrid products – credit products that have securities issues, and will require heavy coordination.

    Rep. Himes (D-CT):
    Comment: Concerned that investors may lose sense of their responsibility as government regulatory reform is expanded.
    A: As a personal view, the country does not do a good job educating the public as to the risks of investments.

    Q: What are your visions on culture, compensation of the SEC and its people?

    A: Need to be able to get the employees to take risk and face cutting-edge issues. Must go beyond rule writing and enforcement cases.

    Rep. McCarthy (R-CA):

    Q: How is revision mark to market going to impact commercial and real estate assets?

    A: (1) Fair value guidance from FASB makes clear don’t have to price assets at fire sale prices & (2) with other than temporarily impaired (OTTI), which allows banks to recognize fair value declines from volatility, interests rates. Can’t speak as to how bank regulators will apply accounting guidelines.

    Rep. Peters (D-MI):

    Q: Would legislation be helpful delegating specific authority to the SEC?

    A: Yes, specifically with executive compensation and proxy actions. Can’t hurt to have the backstop with statutory authority.

    Q: Other reform measures with corporate governance that would require specific statutory authority?

    A: The SEC is focused on access to proxy materials, additional proxy disclosure rules, disclosures related to environmental issues

    Rep. Putnam (R-FL):

    Q: Chairman Cox suspended short sales and later said it was a regretful move, and that costs outweighed benefits.

    A: He did make that statement. What the SEC did last fall was to move quickly and implement emergency measures of various sorts. They have decided to not make emergency decisions in a quick fashion again.

    Q: Will money market fund proposed rules lead to excessive risk taking?

    A: The temporary facility ends in a few months, and the trend since implementation is for funds to act much more conservatively than to take additional risk.

    IV. Second Round of Questions & Answers

    Rep. Bachus (R-AL):

    Q: Are you concerned of changes to FASB accounting rules and how it may impact securitization markets?

    A: The SEC is interested in revitalizing the asset-backed securities market and has made many policy suggestions.

    Q: Can the SEC leverage the expertise of existing and self-regulating organizations?

    A: Based on experience with FINRA, with government oversight, self-regulating organizations can bring great protection to investors and allow SEC to leverage expertise.

    Record will remain open for thirty days for Congressmen to request additional or ask questions of the Chairman in writing.



    [1] Written testimony is attached. This is a summary of oral testimony before the Committee.