Thursday, March 10, 2011

SEC Directors Testify before House Subcommittee on Budget Concerns and Dodd-Frank Implementation

Directors of five SEC divisions testified before Congress against the backdrop of a fierce debate over the Commission’s funding for FY 2012. The Directors jointly stated that their divisions are reforming and improving operations. As part of that effort, they have revitalized and restructured enforcement and examination functions, revamped the handling of tips and complaints, taken steps to break down internal silos and create a culture of collaboration, improved risk assessment capabilities, recruited more staff with specialized expertise and real world experience, and enhanced safeguards for investors' assets.

In response to questions from Members of the House Capital Markets Subcommittee, Meredith Cross, Director of the Division of Corporation Finance, added that the Commission is very carefully reviewing the recommendations of a recent internal study. She added that the SEC does a robust cost-benefit analysis and often changes final rules based on that analysis. More specifically, Robert Cook, Director of the Division of Trading and Markets, testified that when and if the SEC adopts rules on a uniform federal fiduciary standard for advisers and brokers it will include a strong cost-benefit analysis. Mr. Cook pledged that the SEC will work with economists on the rule proposal.

In the joint statement, which also included Eileen Rominger, Director of the Investment Management Division, Carlo di Florio, Director of the Office of Compliance, Inspections and Examinations, and Enforcement Director Robert Khuzami, the officials said that current SEC staffing levels are just now returning to the level of FY 2005, despite the enormous growth in the size and complexity of the securities markets since then. During the past decade, for example, trading volume has more than doubled, the number of investment advisers has grown by 50 percent, and the assets they manage have increased to $38 trillion

The SEC has proceeded with the first stages of implementation of the Dodd-Frank Act without additional funding, the Directors noted, but the next step of making operational the new oversight regimes mandated by Dodd-Frank, such as derivatives, will require significant additional resources. For example, Mr. Cook pointed out that his Division will be responsible for the oversight of four entirely new categories of entities: security-based swap execution facilities, security-based swap data repositories, security-based swap dealers, and major security-based swap participants.

Mr. Khuzami testified that the SEC’s enforcement program continues to face challenges in securing the necessary expertise, human capital and technology resources. The Division must be current with market developments. For example, in the market abuse area, the Division needs the expertise and human capital to understand and analyze new trading technologies such as high-frequency and algorithmic trading, and large volume trading, as well as systemic insider trading and manipulation schemes. In the asset management area, the Division must increase its understanding of issues related to valuation of illiquid portfolios.

Regarding Corporation Finance, Director Cross said that the Sarbanes-Oxley Act
mandate that the Division review the financial statements of all reporting companies at least once every three years. This requirement, coupled with limited resources, constrains the Division's ability to devote sufficient resources to the review of companies that represent the largest portion of U.S. market capitalization. The Division's limited staff is responsible for reviewing the disclosures of approximately 10,000 reporting companies under this mandate, she noted, and also for reviewing registration statements and other transactional filings made under the 1933Act and 1934 Act, such as filings related to capital raising and business combinations.

According to the Director, the challenges of staffing the review program are even greater in light of the Division's new responsibilities under the Dodd-Frank Act. The Division is evaluating its review program with the goal of increasing its focus on large and financially significant registrants and assessing whether additional efficiencies might be gained with regard to its reviews of smaller reporting companies, consistent with its Sarbanes-Oxley obligations.
Under Section 953 of the Dodd-Frank Act, the Commission must adopt rules requiring new disclosures about the relationship between executive compensation and company performance, and the ratio between the median of the annual total compensation of an issuer's employees and the annual total compensation of the issuer's chief executive officer.

Rep. Nan A.S. Hayworth (R-NY) questioned the usefulness of Section 953 and whether there were any reasonable changes Congress could make to the section to make it less burdensome. Director Cross replied that the usefulness of the pay ratio is a call for Congress to make. The Director said that Congress could make the pay ratio disclosure more manageable by changing the median of the annual total compensation of an issuer’s employees to the average annual total compensation. She added that it is the SEC’s job to implement the statute in a workable manner. The SEC has yet to propose rules under Section 953 since Dodd-Frank set no deadline for SEC rulemaking. Director Cross allowed that the statute is fairly prescriptive and leaves no leeway for the SEC in the rulemaking process.

Questioned by Rep. Ed Royce (R-CA) about how the SEC will approach the uniform fiduciary duty standard for advisers and brokers and whether such a standard is needed, Director Cook said that there is a need for a uniform standard based on studies showing that investors are confused over what standard of care is owed to them by different financial intermediaries. When investors walk in the door of a broker or adviser, he said, they should not have to concerned about, or be experts in, different regulatory regimes. Mr. Cook said that any rules in this area will have a scalability element that takes into account different types of businesses.

With regard to implementing the derivatives provisions of Dodd-Frank, Rep. Robert Hurt (R-VA) urged the SEC to provide small banks with an end user exemption. Director Cook assured that the SEC rule proposals contain an exemption for small banks from the mandatory clearing requirement.

The SEC’s proposed rules implementing Section 975 of Dodd-Frank have generated a number of comments, most notably a letter from Financial Services Committee Chair Spencer Bachus. Section 975 directs the SEC to set up an effective registration and examination program for municipal financial advisors. In his letter, Chairman Bachus urged the Commission in developing rules under Sec. 975 to strike a balance ensuring that non-broker-dealer financial advisors to register with the SEC, of which an SEC official has estimated there are only about 260, while not forcing thousands of unsuspecting individuals to comply with yet another regulatory burden that he feels would be detrimental to the very municipal entities Congress is trying to protect.

Echoing the Bachus letter, Rep. Hayworth noted that the proposed rules are overly broad and encompass thousands more individuals than the appox. 260 that the SEC official originally told the Committee would be covered. Rep. Hayworth said that fair, rational and reasonable rules are needed in this area. Mr. Cook acknowledged that it has been a challenge to get the rules right in this area. The SEC seeks to provide legal certainty, he said, while at the same time not allowing the exemptions to overwhelm the rules.

Mr. Cook also testified that the Trading and Markets Division is evaluating whether to make extensive recommendations to the Commission to modernize transfer agent regulation. The Division is also working on three studies required by the Dodd-Frank Act relating to the independence of NRSROs, the standardization of credit ratings, and the process for rating certain structured finance products. In addition, the Division plans to continue to advance discussion on equity market structure, including high frequency trading, and consider appropriate rulemaking responses in the coming months.

The Office of Compliance, Inspections and Examinations has developed a more risk-based approach to the examination program that will enable the more effective use of resources, noted Director di Florio. This approach is necessary, he said, given that the exam program is only able to cover a very small portion of the individuals and entities that register with the Commission, and the disparity between resources and responsibilities is growing as a result of the new requirements of the Dodd-Frank Act. In order to operate a risk-based examination program that effectively identifies and carefully reviews the major risks, he added, the Division will need more examiners, industry expertise and further technological resources.

The financial crisis revealed the need for better oversight of risk at the board and senior management levels, and the need for stronger independence, standing and authority among a firm's internal risk management, control and compliance functions. As a result, the Division is focusing its exams on the overall governance and risk management framework of a firm so as to assess the firm's system of checks and balances.

The Dodd-Frank Act shifted the responsibility for examining many smaller advisers to the states. Rep. Hurt feared that this could burden the states and asked how prepared the states are to handle this new adviser oversight. Director Rominger replied that the states are in a range of preparedness. Director di Florio added that he is conducting an ongoing cross-functional dialogue with the states and with officials at the North American Securities Administrators Association on this matter.

In her testimony, Director Rominger noted that the Dodd-Frank Act changed the universe of regulated entities for which the Commission is responsible by increasing the statutory threshold for SEC registration by investment advisers to $100 million in assets under management and requiring advisers to hedge funds and other private funds to register with the Commission.

Members are concerned with the private equity registration requirement. They do not see private equity firms as a source of systemic risk. Rep. Gary Peters (D-MI) said that private equity firms are not generally liquid and not highly leveraged, and thus do not pose a systemic risk. It makes no sense to treat private equity firms the same as large hedge funds, he posited. Rep. Hurt feared that the over-regulation of private equity firms could lead to less job creation. He asked if the SEC could postpone the private equity regulations until Congress can take further action. Director Rominger noted that the regulations will be scaled to reflect the complexity and size of the firms and a robust cost-benefit analysis will be conducted.

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