On Jan. 14, 2010, SEC Chairman Mary Schapiro and President of NASAA Denise Crawford testified before the Financial Crisis Inquiry Commission,1 regarding their views on the causes of the recent financial crisis. Both witnesses offered some suggestions how regulatory change can assist in averting a similar crisis in the future. In this update we summarize testimony provided by Ms. Schapiro and Ms. Crawford.
SEC Chairman Calls for Increased Market Regulation
Ms. Schapiro indicated that since the crisis the SEC has worked tirelessly to review its policies, improve its operations, and address the legal and regulatory gaps that emerged during the crisis. Ms. Schapiro’s testimony highlighted lessons/issues that she believed came to light during the crisis, and noted how the SEC intends to address them.
1. Enforcement. Ms. Schapiro’s testimony addressed the effect that insufficient risk management and risk oversight by companies involved in marketing and purchasing complex financial products had in creating the crisis. She noted that consistent and vigorous enforcement by the SEC is a vital part of risk management and crisis avoidance, and highlighted enforcement actions brought by the SEC addressing misconduct that led to or arose from the crisis (e.g. auction rate securities, lack of material disclosure and practices of investment banks, subprime lenders, homebuilders, investment managers and others regarding their involvement in the subprime mortgage and mortgage securitization businesses). She also noted that the SEC is enhancing its cooperation with other law enforcement agencies and undertaking internal changes to strengthen its enforcement efforts.
2. Consolidated Regulation of Complex Financial Institutions. Ms. Schapiro noted that a siloed financial regulatory framework lacked the ability to monitor and reduce risks flowing across regulated entities and markets. She pointed to failures in the SEC’s former Consolidated Supervised Entity (CSE) program. She noted in particular the capital adequacy rules which relied on firms’ own risk models but did not sufficiently consider the failures or limits of these models. She also cited a lack of appreciation for the possibility that counterparties would simply stop doing business with well-capitalized institutions or refuse to lend to CSE holding companies even against high-quality collateral. She advocated for a strong, consistent functional regulation of individual types of institutions, along with a broader view of the risks building within the financial system. With respect to broker-dealer regulation, Ms. Schapiro noted that the SEC has undertaken a number of steps to improve its oversight of broker-dealers and minimize the risks in these entities, including: enhancing reporting requirements for broker-dealers with significant proprietary positions and increasing capital requirements.
3. Lack of Regulation in Certain Areas of the Financial Industry.
a. Money Market Mutual Funds. Ms. Schapiro cited the Lehman Brothers’ collapse in 2008, which, combined with the fact that short-term credit markets had ceased to properly function and a concern that other financial institutions might fail, revealed the potential of money market mutual funds to be subject to runs. She discussed the SEC’s actions with respect to the Reserve Fund, which “broke the buck” after the Lehman bankruptcy, and noted that the SEC had already taken steps to prevent future runs on money market mutual funds by proposing rules to tighten the credit quality and maturity requirements for money markets.
b. Asset-Backed Securities. Ms. Schapiro called for securitization requirements to be strengthened and argued that there were gaps in the asset-backed securities (ABS) market. As a result, SEC staff is broadly reviewing SEC’s regulation of ABS including disclosures, the offering process, and ongoing reporting by asset-backed issuers.
4. Transparency and Investor Information:
a. Credit Ratings. Ms. Schapiro cited the fact that too many investors and regulators over-relied on credit ratings, especially for complicated financial products, as a major cause of the crisis. According to Ms. Schapiro, many investors did not appreciate the risks of structured financial products and instead relied almost exclusively on the credit ratings of the securities when making investment decisions. Market participants, regulators and their risk models also made assumptions based on credit ratings that proved incorrect. In response to this aspect of the crisis, she noted that the SEC has undertaken to improve ratings quality by fostering accountability, transparency, and competition in the credit rating industry. In response to questions, Ms. Schapiro stated that the SEC is trying to bring more competition and disclosure into the credit ratings process, and encourage a change in the business model so that it is the investor who pays for the rating, and not the issuer.
b. Compensation. Ms. Schapiro cited perverse incentives and asymmetric compensation arrangements as encouraging significant risk-taking among many financial firms. She pointed to rule amendments proposed by the SEC in December that would significantly improve disclosure in the key areas of risk, compensation, corporate governance and director qualifications as a starting point to address the issue.
c. Corporate Governance. Ms. Shapiro called for enhanced disclosure about the decisions and performance of directors in order to help shareholders make informed decisions about the election of directors. She stated that new rules proposed by the SEC in May of 2009 would help achieve this objective, if approved, by permitting shareholders who satisfy certain eligibility and procedural requirements to include a limited number of nominees to the board of directors in the company’s proxy materials that are sent to all shareholders.
5. Market Regulation. According to Ms. Schapiro, the crisis caused a general concern that financial markets are being stacked against participation by smaller investors. She noted that investor protection and confidence are essential to the efficient flow of capital and the long-term success of financial markets and the economy. In order to promote investor confidence, she stated that the SEC is examining the following issues: unfiltered, or “naked,” access to exchanges and alternative trading systems; dark pools; flash orders; and short sales.
6. Changing Agency Culture. Ms. Schapiro admitted that among the causes and missed opportunities leading up to the financial crisis is the culture of financial regulation itself. Ms. Schapiro’s testimony cited a wide-spread view prior to the crisis that markets were almost always self-correcting. She indicated that an inadequate appreciation of the risks of deregulation resulted in weaker standards and regulatory gaps. She argued that regulatory arbitrage should be reduced by closing gaps created through differing regulatory regimes for financial products that are substantially similar. Ms. Schapiro also pointed to significant gaps in the regulation of over-the-counter derivatives and private fund managers, and she called on Congress to grant the SEC greater authority to supervise these aspects of the market.
NASAA President Gives SEC's Performance a “D Minus”
Ms. Crawford’s testimony before the Commission focused in large part on the lead that state regulators have taken with respect to prosecuting securities-related violations, the failure of financial federal regulators to keep up with the enforcement activities of the states, and the erosion of state securities administrators’ powers by federal preemption. Ms. Crawford also proposed several recommendations to the Commission aimed at addressing the concerns that she raised to them. In response to a question posed by the Commission, she indicated that she would give the SEC a “D minus” for its performance in failing to avert the crisis.
1. Failure of NSMIA. Ms. Crawford criticized the National Securities Markets Improvement Act of 1996 (NSMIA) for significantly reducing the role of state regulators and enforcers in dealing with securities offerings and professionals. Ms. Crawford noted that NSMIA preempted many state regulations and transferred significant enforcement responsibilities from the states to the federal government. NSMIA also prevented the states from taking preventative actions in areas that were substantial contributing factors to the current crisis. She pointed to Nationally Recognized Statistical Rating Organizations (NRSROs) and the private offering exemption as areas where NSMIA’s impact created gaps in regulation. In particular, she noted that, with respect to private offerings, while there may be federal requirements for private placements to come within the scope of Rule 506, in reality there is no federal regulatory enforcement. The SEC does not review Form D filings and rarely investigates Rule 506 offers.
2. State Regulatory Leadership. Ms. Crawford noted that the actions of state securities regulators in aggressively investigating and prosecuting systemic securities fraud have been met by federal securities regulators with misguided attempts to curb the reach of state regulators. She noted that state securities regulators were ahead of the SEC in the investigation of securities analyst conflicts and “market timing” in mutual funds, and particularly criticized the SEC for its delay in investigating the recent auction rate securities cases.
3. Texas Enforcement. In discussing Texas enforcement cases, Ms. Crawford again took the opportunity to criticize NSMIA, observing that it had the consequence of severely limiting oversight of an offering made within a single state. Despite the fact that a Rule 506 offering can be made in a number of jurisdictions, preemption applies. She highlighted a few significant cases in the state in which NSMIA hampered the state’s ability to investigate securities violators.
4. State Securities Enforcement. Ms. Crawford praised state securities regulators for their enforcement successes over the past few years and noted that from 2004 through 2008, state securities regulators conducted more than 11,700 enforcement actions, which led to $238 million in monetary fines and penalties assessed and more than $3.7 billion ordered returned to investors, resulting in a total of more than 4,030 years in prison for those found responsible for the fraud. She pointed to this as a reason for her belief that it defies common sense to preempt state securities regulators through federal rulemaking.
5. Impediments to State Securities Regulation. Ms. Crawford stated that she is troubled by the fact that states have faced efforts to preempt state authority through federal rules and regulations that ignore clear statements of Congressional intent. She argued that in some instances, state investigations into corporate abuses that federal officials missed, resulted not in reform at the federal level, but in criticism of the states. She also noted that some federal agencies have responded to state enforcement activities by proposing regulations broadly preempting state law. According to Ms. Crawford, state involvement drives the performance level of all participants upward and provides protection against the possibility of regulatory capture.
6. Recommendations. The numerous recommendations for reform that Ms. Crawford proposed to the Commission included: restoring state authority for the regulation of Rule 506 offerings; restoring the provisions of the Glass-Steagall Act to discourage the excessive risk taking culture within institutions with federally insured deposits; increasing the state regulation of investment advisers; and establishing a “systemic risk council” in which both state and federal regulators can analyze and identify factors contributing to systemic risk.
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This article was originally published by Bingham McCutchen LLP.