Monthly Archives: October 2009

Bringing Transparency and Oversight to the OTC Derivatives Market

(Editor’s Note: The post below by Chairman Schapiro is a transcript of her testimony to the House Committee on Agriculture hearing regarding the regulation of over-the-counter derivatives markets last week.)

I. Introduction

Chairman Peterson, Ranking Member Lucas, Members of the Committee:

Thank you for the opportunity to testify on behalf of the Securities and Exchange Commission [1] concerning the regulation of over-the-counter (“OTC”) derivatives and, in particular, the Over-the-Counter Derivatives Markets Act of 2009, which was proposed in August by the Department of the Treasury. I am pleased to appear with CFTC Chairman Gary Gensler with whom I have worked closely over the last several months on a variety of issues. As you know, our two agencies have already begun an ambitious program of joint work to better harmonize our rules and procedures. Earlier this month, we held two days of joint hearings that highlighted some of the key differences in our regulatory approaches. We are eager to address these issues. Although some differences may remain over time, I believe this process will help ensure that any differences are justified by meaningful distinctions between markets and products and the others will be harmonized and improved. I also look forward to continuing our joint efforts to push for real regulatory reform.

The recent financial crisis has revealed serious weaknesses in U.S. financial regulation. Among them were gaps in the existing regulatory structure; failures to enforce existing standards; and failures to adapt the existing regulatory framework and provide effective regulation over traditionally siloed markets that had grown interconnected through globalization, deregulation and technological advances. Fixing these weaknesses is vital, particularly in the current market environment, and it is a goal to which the SEC is absolutely committed.

One very significant gap in the regulatory structure was the lack of regulation of OTC derivatives, which were largely excluded from the regulatory framework in 2000 by the Commodity Futures Modernization Act.

It is critical that we work together to enact legislation that will bring greater transparency and oversight to the OTC derivatives market. The derivatives market has grown enormously since the late 1990s to approximately $450 trillion of outstanding notional amount in June 2009.

This market presents a number of risks. Chief among these is systemic risk. OTC derivatives can facilitate significant leverage, result in concentrations of risk, and behave unexpectedly in times of crisis. Some derivatives, like credit default swaps (CDS), can reduce certain types of risk, while causing others. For example, CDS permit individual firms to obtain or reduce credit risk exposure to a single company or a sector, thereby reducing or increasing that risk. In addition to obtaining or reducing exposure to credit risk, a CDS contract participant will take on counterparty and liquidity risk from the other side of the CDS. Through CDS, financial institutions and other market participants can shift credit risk from one party to another, and thus the CDS market may be relevant to a particular firm’s willingness to participate in an issuer’s securities offering or to lend to a firm. However, CDS can also lead to greater systemic risk by, among other things, concentrating risk in a small number of large institutions and facilitating lax lending standards more generally.

These risks are heightened by the lack of regulatory oversight of dealers and other participants in this market. This combination can lead to inadequate capital and risk management standards. Associated failures can cascade through the global financial system.

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Proxy Access and the Balance of Power in Corporate Governance

This post comes to us from Roy J. Katzovicz of Pershing Square Capital Management, L.P.

Our experience with concentrated, long-term investments in large, public companies has taught us that the overwhelming majority of corporate directors are smart, diligent, and capable business people trying the best they can to faithfully discharge their fiduciary duties. They do not, however, always get it right.

Something is broken in corporate America. Particularly over the last decade, prudent risk management took a back seat to the quest for short term profits. Now we are all suffering the consequences. There is, however, reason for optimism. A number of tectonic trends in corporate governance appear to be converging, and a subtle rebalancing of power between management, their boards of directors and shareholders appears likely. We think that is a good thing.

Engaged shareholders with meaningful stakes in the companies in which they invest have the potential to regulate corporate conduct through private and market behavior. The existing tools of shareholder engagement, however, have not proven to be sufficient or optimally suited for that task. We believe that the SEC’s proposal to require public companies to include shareholder nominees in corporate proxy materials goes a long way toward better equipping shareholders to be more effective monitors of corporate behavior and, as a result, another force for good corporate governance.

We applaud this initiative and view it as a market-based solution in that the government is now trying to empower market actors to manage risk rather than trying to achieve the same goal through direct government intervention into the day-to-day affairs of corporations.

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Unblocking Corporate Governance Reform

(Editor’s Note: This post is Lucian Bebchuk’s most recent column in his series of monthly commentaries titled “The Rules of the Game” for the international association of newspapers Project Syndicate, which are available here. The column builds on Investor Protection and Interest Group Politics, an article co-authored by Professor Bebchuk and Professor Zvika Neeman that puts forward a theory of how interest group politics affect investor protection reforms.)

When they met earlier this month, G-20 finance ministers and central bankers called for global improvements in corporate governance. Such appeals are often heard, but powerful vested interests make it hard for governments to follow through. So, if serious reforms are to be implemented, strong and persistent public pressure will be needed.

Many countries provide investors in publicly traded firms with levels of protection that are patently inadequate. Even in countries with well-developed systems of corporate governance, arrangements that are excessively lax on corporate insiders persist. In the United States, for example, insiders enjoy protections from takeovers that, according to a substantial body of empirical evidence, actually decrease company value.

Lax corporate governance rules are not generally the result of a lack of knowledge by public officials. Political impediments often enable lax arrangements to linger even after they are recognized as inefficient.

Ordinarily, corporate governance issues are not followed by most citizens. As a result, politicians expect that their decisions on investor protection will have little direct effect on citizens’ voting decisions. By contrast, interest groups with big stakes in the rules follow corporate governance issues closely, and they lobby politicians to get favorable regulations.

The group that, in normal times, can be expected to have the most influence is that which consists of insiders within publicly-traded companies. Corporate insiders are an especially powerful lobbying group because of their ability to use some of the resources of the companies under their control. They have the power to direct their firms’ campaign contributions, to offer positions or business to politicians’ relatives or associates (or to politicians upon retirement), and to use their businesses to support issues and causes that politicians seek to advance.

Because insiders gain the full benefits that arise through lobbying for lax corporate governance rules, while their firms bear most of the costs of such lobbying, insiders have an advantage in the competition for influence over politicians. Their lobbying, which is carried out at the expense of their companies, is subsidized by their shareholders.

While individual investors cannot be expected to invest in lobbying for stronger investor protection, it might be hoped that institutional investors – mutual funds, banks, insurance companies, and so forth – will do so. Institutional investors receive funds from individuals and invest them in publicly traded companies. Because institutional investors invest substantial amounts in such companies, they should be well informed about corporate governance issues.

But institutional investors usually do not provide a sufficient counter-weight to lobbying by corporate insiders. In contrast to corporate insiders, institutional investors cannot charge the costs of lobbying to the publicly traded companies whose investor protection is at stake. In addition, depending on their relationship with their own investors, some institutional investors (for example, mutual fund managers) may capture only a limited fraction of the increase in value of their portfolios as a result of governance reforms. This reduces the willingness of institutional investors to invest in counteracting insider lobbying.

Moreover, those who make decisions for institutional investors often have interests that discourage lobbying for stronger constraints on corporate insiders. Some institutional investors are part of publicly traded firms, and are consequently under the control of corporate insiders whose interests are not served by new constraints. And even those institutional investors that are not affiliated with publicly traded companies may have an interest in getting business from such companies, making these institutional investors reluctant to push for reforms that corporate insiders oppose.

So, interest-group politics commonly produce substantial obstacles to reform of corporate governance. However, some events – such as a wave of corporate scandals or a stock market crash – can interrupt the ordinary pro-insider operations of interest-group politics by leading ordinary citizens to pay attention corporate governance failures.

When citizens become so outraged that their voting decisions may be affected by politicians’ failure to improve investor protection, public demand for governance reform can overcome the power of vested interests. Indeed, most major governance reforms occur in such circumstances. In the US, for example, new securities laws were passed following the stock market crash of 1929, and the Sarbanes-Oxley Act was adopted in 2002, in the immediate aftermath of the collapse of the Internet bubble and the Enron and WorldCom scandals.

By creating a large public demand for reforms, the current crisis offers another opportunity to improve governance arrangements. This opportunity should not be missed.

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