Making Investors a Priority in Regulatory Reform

Editor’s Note: The post below by Commissioner Luis Aguilar is a transcript of remarks by him at the recent 2009 Independent Directors Conference Workshop in Boston.

It is a pleasure to be here with all of you at the 2009 Independent Directors Conference Workshop to share my views on the regulatory reform issues currently being discussed. I do have to mention that all the views I express today are my own and do not necessarily reflect those of the Commission, the individual Commissioners, or the staff.

I welcome the opportunity to talk with you today. As a practitioner in the securities industry for thirty years who often advised boards of directors, including mutual fund boards, I am familiar with your work and know its importance. I have the utmost admiration for independent directors. You more than anyone have to exemplify the principle that — laws tell you what you can do but values inspire what you should do. As fiduciaries, you play a critical role in setting the appropriate tone at the top and overseeing some of the most important aspects of the fund’s business from keeping fees in line to negotiating important contracts.

Your efforts are crucial to safeguarding the retirement savings and investments of hard working men and women. At the end of 2008, mutual funds, including money market funds, were collectively responsible for approximately $9 trillion of investors’ monies invested in countless corporations, municipalities and myriad investment opportunities. These assets represented the savings of over 92 million individuals.

I have had the distinction of serving on the Commission during “transformational” times, to say the least. I took office at the end of July 2008 and literally my first two months were filled with unprecedented Commission action — running the gamut from being involved with some of the SEC’s largest settlements ever in cases involving Auction Rate Securities to an unprecedented amount of emergency rulemaking and Commission orders.

Now even though the financial crisis continues, the rapid response phase of the crisis is giving rise to discussions of reform resulting from that crisis. In fact, the issues being discussed could very well lead to the largest wholesale regulatory restructuring this country has seen since the great depression. For example, we at the SEC currently find ourselves enmeshed in parallel discussions about the structure of the financial regulatory system, the SEC’s role in such a system, and the regulation of entities under our jurisdiction.

Like me, you too have the opportunity and challenge of representing investors in a time of “transformation.” The global financial crisis has brought us to a point where transformation of existing financial regulation is a given.

The opportunity to take a fresh look involves all of us here today, we at the SEC, and you as fiduciaries, overseeing trillions of dollars that represent a substantial portion of our Nation’s wealth.

Today, I hope we will share thoughts on how to move forward. I plan to discuss three main topics:

• the SEC’s role in regulatory reform,

• the role of a systemic regulator, and

• the role of independent directors.

Regulatory Reform

I welcome the SEC’s involvement in regulatory reform. The SEC has a vital role to play as the only regulator entrusted with advocating for investors and charged with overseeing the integrity of the capital markets. In these times, the SEC is needed more than ever. If the SEC didn’t exist, it would need to be invented. The SEC’s mission is a necessary foundation for any financial system.

It is true that the SEC must undergo its own transformation. I’ve been very vocal about a number of changes the SEC should make and about the Congressional action needed to address gaps in the SEC authority, and the actions needed to provide the SEC with the teeth and resources it needs to aggressively fulfill its mission to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. Some of the changes I have been advocating are happening as we speak, particularly in our Division of Enforcement. I care a great deal about investors and the SEC, and I’ve spoken out so much about needed changes to the SEC’s enforcement program, that I’ve been referred to as the “Enforcement Commissioner.” Today, however, I want to focus on the broader issue of “regulatory reform.”

To start, I would like to make clear the magnitude of what is being discussed by the words “regulatory reform.” In today’s world, we are inundated with news stories and pundit commentary about regulatory reform and predictions about what will happen. With all of the requests for sweeping reform, not only are particular regulations being discussed, but the entire regulatory structure seems to be on the table. For example, just as there are extensive discussions about the greater regulation needed for hedge funds, credit default swaps and other types of financial instruments, in the same breath there is a parallel conversation about how our financial regulatory system should be re-structured both domestically and internationally. The breadth of the topics on the table is extensive.

This momentum for reform arising out of the crisis presents an opportunity to come out with a stronger and more robust financial regulatory system, but only if we do this right.

Definition of Systemic Risk

The SEC, a capital markets regulator that puts investors first, is integral to a modern regulatory system that pays attention to overarching systemic risk. In reforming our system, Congress, the administration, and other interested parties have to remember that financial services exist to serve investors and our markets, and a focus on investors is absolutely essential to any credible regulatory restructuring.

Terms like “systemic risk” are mentioned so often it is easy to believe that there is a common understanding of the term, but this is not the case. This lack of a common understanding is important because how you define systemic risk directly influences your ideas about how the financial regulatory system is structured. Many think of the regulation of systemic risk as being primarily focused on preserving the viability of institutions that are “too big to fail.” But this definition of systemic risk can result in a financial regulatory model that focuses on institutions, not investors, and positions a government regulator to pick winners and losers among companies at the expense of investors and market certainty.

Instead, systemic risk regulation should focus on ensuring the continuation of systemically important market functions, and on investor protections. This can be accomplished by putting in place systemic risk regulation that pro-actively regulates to prevent institutions from being too big to fail in the first place. This regulation must do more than set prudential standards.

The process must also involve identifying the systemically important market functions that an entity provides and work to isolate these functions within the entity. The objective would be to ensure that the functions can be separately maintained should other parts of the entity fail. The regulation could also provide for cross-entity relationships to allow one or more entities to step in and continue the functions seamlessly. For example, let’s think about the SEC regulation of the national securities market system: if the NYSE-Arca systems were to fail, the SEC has designed our market system so that NASDAQ would pick up the important market functions.

In short, systemic risk regulation should focus on the continuation of market functions, and not necessarily institutions.

Relationship between SEC and Systemic Risk Regulator

If systemic risk regulation is truly focusing on the overarching risk concerns, the systemic risk regulator should be viewed as a supplement to — rather than a replacement for — the primary regulator, such as the SEC.

Currently, there are many models of regulatory reform being proposed with regard to a potential systemic risk regulator. The options range from a monolithic systemic risk regulator to a council of regulators serving as the systemic risk regulator.

While there are advantages and disadvantages to the various models, one model that seems to offer a comprehensive and realistic option is to establish a council of regulators. Moving forward with a “council of regulators model” would present a number of issues to be worked through and would require input from the regulators who would come together to oversee systemic risks. Some of the key issues that would need to be considered are the following:

Independence. First, a systemic risk regulator must be an independent entity free from political influence. Independence has served financial regulators well in the past and must be maintained.

Work product and process. Second, the council of regulators should adopt work processes that result in organized information sharing and efficient deliberation and decision-making. While sharing and analysis of the information is the primary goal, there are questions as to whether the council would also make formal decisions and recommendations or only engage in information-sharing in an organized way.

Authority. Third, the council of regulators should be designed to work harmoniously with the primary regulators and to leverage the expertise of the primary regulators. While this should be the starting point, there are questions regarding how much authority the council of regulators should independently possess.

• For example, should the council of regulators have separate information collection powers, or should it direct inquiries through the appropriate member regulator to avoid duplication?

• Should the council of regulators have access to a federal credit facility to aid in orderly resolution of risks or should this be left to a primary regulator? What would be the amount available under the facility and what would be the conditions to access it?

• Another grant of authority that might be considered is whether the council of regulators, or a primary regulator, should be able to seize institutions. What would be the conditions on this power?

Membership. Finally, the membership for this council should be focused on the fact that a financial system is really a set of functions performed by institutions for allocating private capital. The financing of business and providing capital occurs through the private capital markets and through the banking sector. Thus, the council should be composed of the primary regulators with extensive expertise in these areas.

Clearly, the SEC, as the primary regulator of the capital markets, would be a vital participant in such a council. The SEC would bring to this council its 75 years of broad market experience, in addition to its focus on investor protection, to this body. Regardless of the eventual model adopted for regulatory reform, it must be one that prioritizes the needs of investors and markets rather than diminishes their value.

Between the press and the pundits, it has become obvious that there is some confusion as to what the SEC currently does. Let’s be clear — the SEC is the only regulator charged with protecting investors, maintaining fair and orderly markets, and promoting capital formation. The SEC is and should be considered the first line of defense for the financial regulatory system with respect to the capital markets and investors.

Investors’ confidence has been deeply shaken by the lack of transparency and credible information of some aspects of our current markets. An empowered SEC, appropriately funded and authorized by Congress, is a key participant to establishing a level playing field for investors and market participants alike.

Risk of Making a Mistake on the Systemic Risk Regulator

I cannot emphasize enough that currently the structure of the entire domestic and international financial regulatory system is being questioned. I recently represented the Commission at a meeting of the Coalition of Securities Regulators of the Americas. Representatives came from countries across the Americas including Canada, Mexico, and Brazil. The conference included several meetings focused on developing the best system for regulating financial services on an international scale. The same topics were addressed at the recent G-20 meetings. It is more than clear that the world is focused on the same issues of regulatory reform as we are in the U.S.

As independent directors, you should not be sitting on the sidelines thinking that the broader regulatory reform debate does not impact you. Decisions made as to the structure of the systemic risk regulator will have a profound impact on how you are regulated, what the primary objectives of the regulator are, and what kind of relationship you have with regulators.

Money market funds, mutual funds, and other organized pools of private capital, represent a financing model that in many cases would compete with financing provided under a banking model. A systemic risk regulator structured as a council could reflect the broader perspective of the entire financial system rather than being steeped in only one way that businesses raise capital. For example, a systemic risk regulator focused on banking regulation may not be as concerned about adverse effects on competitors to banks.

There is also a real concern in all the momentum for change that a regulatory structure could emerge that weakens current investor and market protections. It is important to make sure that regulatory reform does not result in a system that loses sight of its purpose.

Systemic Risks and Money Market Funds

One segment of the mutual fund industry that has drawn specific focus is the money market fund industry that holds close to $3.9 trillion of assets for millions of fund shareholders. Money market funds, as this audience knows well, are low-cost, efficient cash management tools that provide a high degree of liquidity, stability in principal value, and a market-based yield. These entities are highly regulated and a money market fund’s portfolio is subject to regulatory restrictions on quality, maturity, and diversity.

When investors lost confidence after the failure of Lehman Brothers and the resulting “breaking of a buck” by the Reserve Primary Fund, money market funds experienced extraordinary redemption requests. These withdrawal requests resulted in severe liquidity pressures, and impaired the ability of funds to provide liquidity to the short term money markets.

In that environment, a systemic risk concern arose from the potential of more money market funds breaking the buck and the susceptibility of the entire industry to sharp withdrawals. During that time, our staff worked closely with staff from the Federal Reserve and Treasury to take action in support of money market funds to quickly restore investor confidence. Relatively quickly after these actions took place, money market funds resumed their normal function as a source of liquidity in the short-term financial markets. This cooperative effort is an example of what a systemic risk council of regulators should be able to accomplish.

In fact, money market fund assets are increasing. This increase in money market fund assets during the current fiscal crisis illustrates that money market funds are viewed by investors as safe havens for their liquid assets.

More recently, as you know, a plethora of ideas related to money market funds have been set forth by groups including the Group of 30, Treasury Secretary Geithner, and the Investment Company Institute. At the SEC, staff within the Division of Investment Management is working in earnest to take in all the input and apply its expertise to design the best proposal possible for the way forward. You can expect that the SEC will soon announce plans to strengthen the regulatory framework around money market funds.

Board Responsibility

As important as it is to get the right model for overseeing and managing systemic risk, in a real sense the process starts with the individuals that have the first opportunity to address how the many businesses manage the risks that they take on a day-to-day basis. In addition to engaging in the debate on regulatory reform, where your expertise and views will be important, this is an issue where I think mutual fund directors — and independent directors, in particular — can take the lead.

While the Investment Company Act of 1940 establishes disciplined standards by which investment companies need to operate, it is the directors, particularly the independent directors, who must see to it that the companies and their management comply with the rules. But that’s just the beginning — as a fiduciary, a director’s principal responsibility is to watch out for investors’ interests.

Unfortunately, investors have not always felt like the directors have been diligent in protecting their interests and have levied criticisms that directors may be too quick to agree to the demands of fund management. Specifically, there have been questions about whether directors sufficiently challenge and question fee arrangements, whether they take seriously ethical breaches such as short-term trading or late-trading, and whether they are sufficiently diligent in managing conflict of interests.

That being said, the vast majority of mutual fund directors I’ve known take their responsibilities very seriously. They fully understand the unique oversight role they have. They know how important it is to go beyond the specific obligations of the 1940 Act — such as approving the advisory contract, and generally monitoring and protecting against conflict of interests. They know they need to always be vigilant — by asking questions whenever they don’t understand something and challenging fund management when contemplated actions might run counter to the interests of fund shareholders.

As the discussions about a systemic risk regulator and regulatory reform continue, independent directors have the opportunity to take the lead in restoring investor confidence. It is up to you to set the tone for the Fund and for all of its service providers. Fund directors must make sure that the investors’ interests are protected.

Today’s time is too limited to discuss all the things a board needs to do — but a few to specifically mention are:

• making sure that adequate resources are dedicated to the legal, accounting and compliance functions;

• regularly challenging the effectiveness of the policies, procedures and internal controls of the fund and its service providers; and

• demanding accountability from those to whom responsibilities have been delegated.

These are key responsibilities.

Two additional areas that merit particular attention because they set the tone for a fund’s culture are: risk oversight and selection of directors.

Board Leadership on Risk Oversight

Risk oversight — or more accurately, the lack of risk oversight — has received a lot of attention for its role in the economic crisis. Risk oversight is a role that fund investors expect fund directors to diligently play.

I appreciate that managing risk is a broad topic that can encompass a full day’s discussion, much less the short time we have today. However, it’s important to underscore that your responsibilities require you to go beyond merely assuring that a fund is complying with the 1940 Act. Directors must also give particular focus to overall risks being taken by fund management.

As investors in other companies, it is also appropriate for you to make sure that fund management appreciates the risk being taken when they invest in a particular entity.

Mutual funds are often the largest investors in companies and accordingly wield the most votes on behalf of the company’s shareholders. I would encourage you to make sure that fund management is adequately monitoring the risks being taken by such companies. In particular, I think your fund shareholders would welcome your efforts in ensuring that management of the companies in which the fund invests are not being rewarded for taking excessive risks.

For example, are your fund managers paying attention to see if compensation structures unduly encourage excessive risk taking? Recent statistics seem to indicate that funds may not be paying enough attention. The Corporate Library and the American Federation of State, County, and Municipal Employees analyzed mutual fund votes in 2008 annual shareholder proposals. The report stated that in 2008, the 26 mutual fund groups included in the study voted in favor of management compensation proposals 84% of the time. By comparison, the average level of support for management proposals on compensation issues was 82% in 2007 and 75.8% in 2006. Thus, the study found that mutual funds were increasingly supportive of management positions on proposals dealing with executive pay. Although this statistic alone doesn’t shed light on every case-by-case determination, given all that we read about excessive compensation, it does raise an eyebrow as to whether there is appropriate focus on this issue.

Diversity in the Boardroom

As I near the end of my remarks, I also want to mention the important of diversity in the boardroom. In an increasingly global environment, the ability to draw on a wide range of viewpoints, backgrounds, skills, and experience is critical to a company’s success. Studies indicate that diversity in the boardroom results in real value for companies and shareholders. In fact, the California Public Employees’ Retirement System’s recently commissioned a report that found companies that have diverse boards perform better than boards composed of directors with similar profiles in terms of ethnicity, gender, and skills sets. The report — Board Diversification Strategy: Realizing Competitive Advantage and Shareowner Value — stated that companies without ethnic minorities and women on their boards eventually may be at a competitive disadvantage and have under-performing share value. The report also found that a selected group of companies with a high ratio of diverse board seats exceeded the average returns of the Dow Jones and NASDAQ indices over a five-year period.

In spite of the documented benefits, there remains a persistent lack of diversity in corporate boardrooms across this country. For example, in 2004, the Alliance for Board Diversity compiled statistics about the composition of the boards of directors of Fortune 100 companies and found the majority of board members, 72% were white American men, and only 28% of the board seats were held by women and minorities. Unfortunately, these board statistics have stayed virtually unchanged for the last four years.

One reason for these abysmal statistics is that director candidates are often selected because of a connection to a current board member or member of management. I consider the decision to nominate someone to a board of directors an important one — as is the decision to accept a seat. While I understand the impulse to nominate the familiar, I worry that this approach limits the talent pool for board members.

I want to encourage everyone in this room to prioritize and implement practices to increase corporate board diversification. It is imperative to have processes in place to be able to identify diverse candidates. The nominating committee should follow policies and procedures which require that, in all future assessments of board needs, to include the development of a diverse slate of candidates in advance of a board opening becoming available. In today’s environment, diversity in the boardroom is a business necessity and I urge you to take action to support it.


I have a great deal of respect for the contributions of independent directors. As lawmakers and regulators in the U.S. and around the world begin to draft financial regulation, it will be vitally important to build upon the strengths in the current system. The capital markets and financial services in this country are in a position of public trust. They must operate under the highest standards of integrity and honesty. Investors expect no less of lawmakers and regulators.

Investors also expect no less of you. In fact they expect more. As fiduciaries you owe it to them to put them first. And to aggressively protect their interests. It is important work, and the SEC will be there to support your efforts.

Thank you for the opportunity to be with you today.

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