By James Hamilton, J.D., LL.M.
The House Financial Services Committee has passed legislation reforming the SEC to strengthen its powers, better protect investors, and efficiently and effectively regulate the securities markets. The failures to detect the Madoff and Stanford Financial frauds demonstrated deep deficiencies in the existing securities regulatory structure. The Act doubles the authorized funding for the SEC over the next 5 years and provides dozens of new enforcement powers and regulatory authorities. Thus, the SEC will be able to enhance its enforcement programs and gain the tools needed to better protect investors and police the markets. The Investor Protection Act, HR 3817, also authorizes the SEC to collect user fees from advisers to cover the costs of compliance examinations and investigations.
The Madoff fraud revealed that the Public Company Accounting Oversight Board lacked the powers it needed to examine the auditors of broker-dealers. The $65 billion Ponzi scheme also exposed faults in the Securities Investor Protection Act, the law that returns money to the customers of insolvent fraudulent broker-dealers. The Investor Protection Act closes these loopholes and fixes these shortcomings.
Broker-dealers are brought under the PCAOB oversight regime. The Board will inspect the audit reports on broker-dealer financial statements; and will have investigatory, examination and enforcement authority over the auditors of broker-dealers. In addition, brokers and dealers would be brought into the Board’s funding scheme by paying a fee allocation in proportion to their net capital compared to the total net capital of all brokers and dealers that are not issuers, in accordance with the rules of the Board. The draft also authorizes the Board to refer an investigation concerning a broker or dealer’s audit report to the relevant self-regulatory organization. Moreover, the Board is authorized to share with the SRO all information and documents received in connection with an investigation or inspection without breaching its confidential status.
The Garrett Amendment would change the name of the PCAOB to Auditor Oversight Board. In addition, the Jenkins-Garrett Amendment would create an ombudsman within the Auditor Oversight Board to act as a liaison between the Board and registered accounting firms and issuers with regard to the issuance of audit reports. The ombudsman would also deal with any problem that registered firms or issuers may have in dealing with the Board resulting from the Board’s regulatory activities, particularly with respect to internal control over financial reporting and audit attestation under Section 404 of Sarbanes-Oxley.
Currently, under the Securities Investor Protection Act, any amount advanced in satisfaction of customer claims may not exceed $500,000 per customer. If part of the claim is for cash, the total amount advanced for cash payment must not exceed $100,000. The draft would increase the cash payout to $250,000 and adjust it for inflation.
In addition, the draft provides that persons who falsely represent, with an intent to deceive or cause injury to another, that they are a member of SIPC or that any person or account is protected by SIPC, is subject to a fine of $250,000 or five years in prison. Similarly, any Internet service provider that transmits or stores any material containing misrepresentation of SIPC membership will be liable for any damages caused thereby, including damages suffered by SIPC, if the service provider knew or should have known that the material contains the misrepresentation and fails to act expeditiously to remove, or disable access to, the material.
An amendment by Chairman Frank would move the regulation of thousands of investment advisers from the SEC to the states. The amendment would raise the assets under management trigger from $25 million to $100 million. And it would authorize the SEC to move it even higher. Thus, the Amendment sets up state oversight of investment advisers with up to $100 million in assets under management. The $25 million trigger for state regulation was set in the National Securities Markets Improvement Act of 1996.
An amendment offered by Ranking Member Bachus would permit the SEC to delegate responsibility to the broker-dealer SRO, FINRA, to enforce compliance by its members and associated persons with the provisions of the Act. In other words, the amendment would empower FINRA to enforce the fiduciary duty provisions in the Investment Advisers Act against not only broker-dealer members but also against any affiliated investment advisory firm or any associated person. Additionally, the amendment would give FINRA sweeping rulemaking authority.
In a letter to the Committee, the financial planning industry expressed concern that the Bachus Amendment would extend FINRA’s authority to approximately 88 percent of investment adviser representatives and implicate application of the fiduciary duty to investment advice. The industry also claimed that the expansion of FINRA’s authority would be without precedent and the impact of this new oversight structure would be significant. For the first time, FINRA would be granted authority to regulate people and practices outside the scope of the Securities Exchange Act.
Acting on a recommendation of the Obama Administration, the draft mandates a federal fiduciary standard for brokers and investment advisers in their dealings with retail customers. Under this harmonized standard, broker-dealers and investment advisers will have to put customers’ interests first. The receipt of compensation based on commission or fees will not, in and of itself, be considered a violation of such standard applied to a broker or dealer or investment adviser. The draft would define retail customers as those receiving personalized investment advice from a broker, dealer, or investment adviser for use primarily for personal, family, or household purposes.
The draft also directs the SEC to facilitate the provision of simple and clear disclosures to investors regarding the terms of their relationships with brokers, dealers, and investment advisers and adopt rules prohibiting sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that it deems contrary to the public interest and the interests of investors.
Further, the draft directs the SEC to adopt regulations ensuring, to the extent practicable, that the enforcement options and remedies available for violations of the standard of conduct applicable to a broker or dealer providing investment advice to a retail customer are commensurate with those available for violations of the standard of conduct applicable to investment advisers under the Investment Advisers Act.
The legislation sets up a whistleblower bounty program that creates incentives to identify wrongdoing in the securities markets and reward individuals whose tips lead to successful enforcement actions. With a bounty program, there will effectively have more cops on the beat in our securities markets.
Because mandatory arbitration of brokerage disputes has limited the ability of defrauded investors to seek redress, the draft would authorize the SEC to bar these clauses in brokerage firm customer contracts. The Neugebauer Amendment would direct the US Comptroller General to conduct a study on the costs of using the FINRA-operated arbitration system as opposed to the costs of litigation and submit a report to the SEC’s congressional oversight committee in one year. Specifically, the report must determine the percentage of recovery of the total amount of a claim in a FINRA arbitration proceeding.
The Miller Amendment authorizes the SEC and CFTC to establish a joint advisory committee to develop solutions to emerging and ongoing issues in the securities and commodities markets. The advisory committee would also serve as a vehicle for discussion and communication on regulatory issues affecting the SEC and CFTC and the markets and the securities and futures industries.
The draft gives the SEC nationwide service of subpoenas for use in enforcement actions under the Securities Act, Exchange Act, Investment Company Act and Investment Advisers Act. Also, the draft would add a new Section 15F to the Exchange Act to provide for the registration of municipal financial advisers. The SEC is authorized to grant exemptions from the registration mandate.
The bi-partisan Garrett-Adler amendment exempts small businesses from the internal control audit attestation reporting requirements contained in Section 404(b) of the Sarbanes-Oxley Act. The amendment language mirrors legislation Rep. Garrett introduced earlier this year, the Small Business SOX Compliance Relief Act, HR 3775.
Although the stated intent of Sarbanes-Oxley was to provide investor confidence in the financial markets through greater accountability and disclosure, the Act has had the unintended effect of creating undue and often unbearable burdens on small businesses. According to Rep. Garrett, there is a place for federal oversight, but the weighty cost of compliance under Section 404 is slowly strangling small businesses. It is diverting valuable resources away from other legitimate business needs; creating massive and tedious documentation requirements; and discouraging the public listing of both international and domestic companies on U.S. markets.
The SEC has repeatedly extended the deadline for non-accelerated filers to begin providing audited assessments of their internal controls over financial reporting, an acknowledgement of continued concern about compliance costs. Although reforms were made in 2007 to relax the guidelines for smaller companies, businesses of all sizes still report excessive compliance costs, as noted in an SEC report from September 2009 .In summarizing survey responses from businesses regarding the benefits of Section 404 compliance, the SEC said that a majority felt that the costs of compliance outweighed the benefits. This was especially true among smaller companies.
The Waters-Peters Amendment would authorize the SEC to implement rules and procedures granting shareholders the opportunity to nominate at least one director to a corporation’s board of directors, a right known as proxy access. In the view of Rep. Waters, the amendment was needed because, without it, the SEC would have most likely faced a lawsuit from corporations and their industry groups alleging that the Commission lacked the authority to grant shareholders this right.
Congress believes that proxy access is necessary for shareholders to have a meaningful choice in exercising their right to vote for board members, and thus to hold boards accountable. Board nominees are typically selected by the very management that the board is meant to oversee, creating a board indebted to management, potentially weakening the board’s accountability and oversight, and diluting the power of shareholders. The amendment provides shareholders with a meaningful say in the process.
Regulation of proxy access and disclosure is a core function of the SEC and is one of the original responsibilities that Congress assigned to the Commission when it was created in 1934. The amendment would create a new federal right to proxy, but would also ensure that the already-written laws on the right to proxy are upheld.
In an effort to address the revolving door problem, the Castle-Spier Amendment orders the US Comptroller General to conduct a study to review the number of SEC employees who leave the Commission to work for financial institutions regulated by the SEC and file a report within one year with the Senate Banking Committee and the House Financial Services Committee. The report must review the length of time these employees work for the SEC before they leave to work for regulated financial institutions.
The report must also review internal controls and recommend the enhancing of such so as to ensure that SEC employees later employed by regulated firms did not assist those firms in violating any SEC regulations during their SEC employment.
Importantly, the Comptroller General must determine if greater post-employment restrictions are needed in order to prevent SEC employees from being employed by regulated firms when they leave the SEC, as well as whether the number of former SEC employees going to the industry has led to SEC enforcement inefficiencies. The report must also identify any information sharing engaged in by the SEC employees while they worked for the Commission.
The IPA calls for studies of SROs and how they might enhance the SEC’s oversight of advisers. Section 304 specifically mandates a study as to whether the present reliance on self-regulatory organizations promotes efficient and effective governance for the securities markets.
The Hodes Amendment adds a new Title to the Act dealing with senior investor protection. NASAA has 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 but rather are conveyed to individuals who pay to attend weekend seminars and take open book, multiple choice tests. NASAA has adopted a model rule designed to curb abuses in this area.
The Hodes Amendment 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 the NASAA model rule. 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.