By James Hamilton, J.D., LL.M.
Noting an almost 50% decrease in disgorgements in 2007, Senate Banking Committee Chair Christopher Dodd and Securities Subcommittee Chair Jack Reed have asked the GAO to review whether the SEC’s Division of Enforcement has sufficient staff and funds to perform its mission and whether there have been fundamental changes in operation to the way they handle cases. The senators wonder if changes have taken place in the Commission’s enforcement philosophy or scope of activity. Separately, Sen. Reed asked the SEC to conduct an analysis of the issues before embarking on a system of mutual recognition, which he called a radical departure from current policy. In remarks at the NASAA public policy seminar, he also called for the reform of the credit rating agencies.
With U.S. markets in disarray, he noted, the SEC and PCAOB have stepped up their efforts to converge and harmonize with international standards. The subcommittee chair is particularly concerned by the timing of the SEC’s mutual recognition announcement, which comes in the midst of a major market crisis that has raised questions about the adequacy of U.S. regulatory oversight.
The senator emphasized how critical it is that the SEC ensure that U.S. investors do not suffer any diminished protections under a system of mutual recognition. This is especially crucial given that no other market enjoys comparable participation by retail investors, or the benefits and responsibilities that such participation brings, he added, and no other regulator is likely to share the SEC’s commitment to protecting U.S. investors, particularly if that protection comes at the expense of its domestic firms.
Thus, he will send the Commission a letter requesting an analysis of issues before undertaking such a radical departure; and follow up with hearings on the topic.
The mutual recognition concept would permit foreign exchanges and foreign broker-dealers to provide services and access to U.S. investors under an abbreviated registration system. This approach would depend on these entities being supervised in a foreign jurisdiction providing ``substantially comparable oversight’’ to that in the U.S.
Also disconcerting to the senator is that the SEC requested less than a 1% increase in its operating budget for 2009. This is a significant concern given that increased demands are being placed on staff and the agency during this critical time. Further, it was recently reported that, with the naming of a director of risk assessment at the SEC, the total number of individuals working in that office had doubled to two. The oversight chair was astounded that this office, which is charged with maintaining the overall process for risk assessment through the SEC and serves as a resource for other offices in their risk assessment efforts, up until last month had only one person working in it.
That said, the senator understands that Chairman Cox has committed to hiring additional staff this year. But one is still left to wonder, he said, why there was such barebones staffing in an office with a critical mission to identify systemic risks.
There must be reform of the credit rating agencies, he posited, as the evidence builds on the shortcomings of the rating agencies and their role in the recent market troubles. As part of the reform, the oversight of credit rating agencies needs to be strengthened. The rating agencies failed to understand the securities they were rating and failed to proactively monitor these securities resulting in stale and inaccurate ratings.
The system was also beset by an incentive structure driven by fees, he said, and a process geared towards fueling the demand for poorly written loans in which each part of the chain delinked as soon as the fees were collected.
In his view, it was a glaring omission on the part of the Treasury’s blueprint not to include a recommendation on how and where credit rating agencies can be better regulated. The SEC either needs to have more authority to ensure that the conflicts are managed appropriately and that the ratings are credible or a new agency needs to be established. Fundamentally, he reasoned, credit rating agencies, like auditing firms, are gatekeepers and, as such, play a critical role in the capital markets.
But, in the end, financial regulators are the ultimate gatekeepers, he observed, and a regulatory structure that limits risk in one area but is unable to contain it in others will ultimately leave all investors exposed to volatility in the financial system. Overall, the SEC and other financial regulators have to more rigorously examine financial institutions and require better disclosures of products sold to investors so that they are aware of the true risks.