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E-MailOn October 23rd, Henry Waxman’s House Committee on Oversight and Government Reform began hearings on regulatory oversight of financial markets. Alan Greenspan, John Snow, and Christopher Cox testified. SEC Chairman Cox, the only currently-serving official to testify, is in a tight corner: in March, the Department of the Treasury proposed a new regulatory structure, dubbed “Pure Functional Regulation”, that would see the responsibilities of the SEC distributed among new agencies. John McCain wants him fired (but that’s not so scary today, is it?) Perhaps most unfairly, he’s been blamed for the Consolidated Supervised Entity program, which was adopted almost a year before he even arrived at the SEC.
It made me think there was a real possibility that the SEC might become a casualty of the credit crisis. I even wondered whether this could mean the end of disclosure-based regulation.
To get some insight, I took a quick email poll of securities law experts.
Recommendation 1 – Keep disclosure-based regulation! It is a good system, and the alternatives are worse.
Disclosure-based regulation of securities transactions has been with us since the enactment, 75 years ago, of the Securities Act of 1933. The ’33 Act and the Securities Exchange Act of 1934, which regulates securities exchanges and provides for periodic disclosure to investors, form an interlocking regulatory structure built on,
“[…] a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it. To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public. This provides a common pool of knowledge for all investors to use to judge for themselves whether to buy, sell, or hold a particular security.” (SEC website)
“No and no,” says Jesse M. Fried, Professor of Law at UC Berkeley, echoing all the respondents: disclosure-based regulation will not disappear, nor should it. In fact, adds Broc Romanek, editor of theCorporateCounsel.net, “I believe the only alternative to disclosure-based regulation for deals is merit-based regulation […] To do that, you would have to grow the SEC (or whatever agency would be in charge of transactions) tenfold or more.”
Merit review is part of the blue-sky law of many states. It consists of an analysis of whether an offering is a good investment. It is also, adds Broc Romanek, “nearly un-American because it would likely result in the government turning down companies that want to raise capital.” An ABA committee on merit regulation summarized the process this way,
“A disclosure review by a merit administrator […] may differ significantly from an SEC review in that it might focus primarily on disclosure of the facts that generate merit problems. […] The key point, however, is that merit review and disclosure review are interrelated, since the examiner may require extensive disclosure of merit issues, such as conflicts of interest and promoter compensation.”
Ad Hoc Committee on Merit Regulation of the State Regulation of Securities Committee of the American Bar Association, Report on State Merit Regulation of Securities Offerings, 41 Bus. L. 785 (1986)- [41 BUSLAW 785].
2. Don’t ditch the SEC. It’s not so bad.
The SEC “has been one of the more successful federal agencies in carrying out its statutory mission,” says Thomas Lee Hazen, the Cary C. Boshamer Distinguished Professor of Law at the U. North Carolina at Chapel Hill School of Law.
Alan R. Bromberg, University Distinguished Professor of Law at the SMU Dedman School of Law, singles out the Division of Enforcement for praise: the SEC, he says “deserves to survive as an enforcer.” He offers more qualified support for the agency’s other functions: “It deserves to survive as a regulator, if it can match its skills to those of the market.”
This distinction, between the SEC’s enforcement activities and its regulatory functions, was also highlighted, in recent Congressional testimony, by a former Chairman of the SEC. Any new regulatory body “must be a law enforcement agency” said Arthur Levitt, Jr. “Vigorous enforcement of the rules of the road is a powerful deterrent to bad behavior.”
The SEC’s functions are apportioned among four divisions: Enforcement, Corporation Finance, Investment Management and Trading and Markets. During the present crisis, the SEC’s own Office of Inspector General has singled out the Division of Trading and Markets for criticism. In a pair of reports (On the Consolidated Supervised Entity program and on Broker Dealer Risk Assessment) issued on September 25th, the OIG reiterated a call made six years ago for T&M to better police the risk assumed by investment banks.
3. Get in the cellar! There’s a Congressional storm brewing.
All the respondents expect some kind credit crisis-related Congressional ado. “No doubt there will be legislative reaction,” says Professor Hazen, while Professor Bromberg foresees that “the next Congress will decide whether SEC survives.”
Reform proposals abound. SEC Chairman Cox, as well as the aforementioned Treasury Department blueprint, has proposed merging the SEC with the agency responsible for regulating derivatives trading, the Commodity Futures Trading Commission. Meanwhile, powerful Congressional Democrats have been publicly discussing the creation of U.K.-like super regulator. Barney Frank, in the Wall Street Journal indicated that he favors creation of a “systemic-risk regulator,” with responsibility for protecting the soundness of the whole financial system. The American Banker reports that Charles Schumer favors consolidating regulation under a single agency. (American Banker, 11/11/08, 2008 WL 21485826)
Even in this overwrought atmosphere, most of the respondents expect the SEC and disclosure-based regulation to survive. Professor Hazen says: “I seriously doubt that it will be the demise of the disclosure-based regulatory approach. […] The current crisis has exposed some regulatory gaps that will probably be addressed in the coming year.”
4. Regulate OTC derivatives!
According to Hazen, “the relevant regulatory failure was the failure to regulate over-the-counter derivatives.” These markets were, in his words, “an accident waiting to happen.” Fried agrees that there should be “more transparency in that market.”
In 1999 Congress passed, and President Clinton signed, the Commodity Futures Modernization Act of 2000 (PL 106-554, 7 USCA 7a-1 et seq). The CFMA, implementing recommedations made by the President’s Working Group on Financial Markets, contained provisions exempting certain derivatives, including credit default swaps, from regulation by the SEC or the CFTC. As Chairman Cox put it: in this “regulatory black hole” grew a market larger than, “the GDP of every nation on earth.” The Depository Trust & Clearing Corporation (DTCC) argues that the OTC derivatives market is only half the size Cox claims it is because he counts each transaction twice, but even using the DTCC’s math we’re talking about a 35 trillion dollar market.
The black hole is beginning to fill with band aids. The State of New York would classify credit default swaps as insurance and regulate the piece of the market written by New York-chartered insurers (approximately 60%). DTCC recently announced the creation of a central clearing facility for OTC derivatives and a database containing information about the largest transactions. Professor Hazen called central clearing of OTC derivatives the “minimum” regulation necessary.
DTCC may be trying to address Senator Tom Harkin’s stated intention (Bond Buyer, 10/16/08, 2008 WLNR 19639053) to create a CFTC-regulated exchange for OTC derivatives.
