Creating Reform That Is Sustainable for Investors

(Editor’s Note: The post below by Commissioner Aguilar is a transcript of his remarks at the Hofstra Investment Management Conference, omitting introductory and conclusory remarks; the complete transcript is available here. The views expressed in this post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission or the other Commissioners.)

Right now there are many voices clamoring to be heard regarding financial reform. This clamor is composed of some recommendations that are intuitive and others that are not. There are those calling for reforms that are limited to the factors that contributed to the crisis and others who see the possibility of broader legislative and administrative action as an opportunity. Some see it as an opportunity to advance their existing commercial interests, and others, like me, see it as an opportunity to reestablish a comprehensive, but flexible, capital markets regulatory framework that can better react to current and future events.

I think it is important to step back and think through the principles that should motivate any proposed reforms. As a regulator standing on the precipice of legislative and administrative action, I think it is important to focus on how things should be rather than how they are. Rahm Emmanuel’s oft-quoted remark that we should not waste a good crisis is absolutely right. I firmly hope that the opportunity will not be wasted. Unfortunately, it is clear that some transformational changes are no longer on the table — such as a merger of the SEC and CFTC. In addition, there are robust efforts underway to scale back the Obama Administration’s effort to regulate the multi-trillion dollar over-the-counter derivatives industry.

My goal for today’s remarks is to discuss an appropriate construct for financial reform and to consider examples from the current debate that exemplify these principles.

My Experience and Perspective

As I look around this room, let me just say that it is a pleasure to be with a group of leaders in the investment management industry. I feel that I am among friends. While I have spent much of my professional career involved in capital formation though public and private offerings, a substantial portion of my career has been spent working in the investment management industry. As some of you know, my experience with the securities industry began in the late 1970s. After three years with the SEC, I spent the bulk of my thirty years as a practitioner focusing on the capital markets. Although many of those years were in private practice in large law firms, I spent most of the nineties and the early part of this decade as General Counsel and Head of Compliance of a large global asset manager.

Having spent my career in the securities arena — but outside of the Beltway — I have often been asked about my transition to DC life. My timing could not have come at a more interesting time. I began my service on the Commission during “transformational” times to put it mildly. I took office at the end of July 2008 and the past fourteen months have been filled with unprecedented events and government action. There is no question that I am serving as an SEC Commissioner at a time when the financial services industry and its regulators are in dire need of reform. In fact, financial reform has unprecedented attention from the White House, Capitol Hill, the media, and the American public — financial reform is generating articles nearly every day on the front page of the Wall Street Journal, the New York Times, and the Washington Post. The opportunity to institute real reform is here and our efforts should be motivated by the proper principles of investor protection and maintaining fair and orderly markets.

Smart, Effective Regulation is Necessary for Strong Capital Markets

In recent remarks by President Obama regarding the role of government in the health care reform movement, he said,

“You see our predecessors understood that government could not, and should not, solve every problem. They understood that there are instances where the gains in security from government action are not worth the added constraints on our freedom. But they also understood that the danger of too much government is matched by the perils of too little, that without the leavening hand of wise policy, markets can crash, monopolies can stifle competition, and the vulnerable can be exploited.” [1]

I agree wholeheartedly with President Obama. Clearly, smart, effective regulation and oversight are necessary building blocks in the foundation for robust and fair capital markets.

But it is not just the laws and rules on the books. It is the fact that historically for decades there has been strong enforcement of these laws. Part of the analysis of what went wrong over this last decade is that many of the appropriate regulators possessed authority to act when they saw questionable activity — but they made affirmative decisions not to act. In essence, they looked the other way. The argument that the market can discipline itself no longer resonates given the amount of evidence to the contrary. Thus, smart, effective regulation includes both the laws on the books — as well as the will to enforce them.

Take the creation of the Investment Company Act of 1940 as an example. The Act was the product of input from the SEC, the industry, and the Congress and was designed to right the abuses in the investment company industry. At the time, Congress recognized that the full-disclosure approach of the Securities Act of 1933 was insufficient to address the potential abuses that are possible when large pools of assets are entrusted to third parties for investment. As a foundation to develop an effective regulatory framework, Congress authorized the SEC to do a three-year study, commonly referred to as the Investment Trust Study, where the Commission uncompromisingly and comprehensively revealed the actual abuses that had occurred, as well as the inherent potential for abuse in a fund structure. As this audience knows only too well, the ultimate legislation set forth in great detail the standards and prohibitions with which the fund industry would have to comply, while also intelligently vesting discretion in the Commission to grant exemptions.

A year after the passage of the Investment Company Act, Alfred Jaretski, a leading investment company lawyer of the time, wrote,

“. . . [i]t is the conviction of the writer that the enactment of the Investment Company Act of 1940, particularly as the result of a cooperative effort, was of primary benefit to the investment company industry. The Act not only protects investors, but in setting specific standards for management affords protection to officers and directors.” [2]

I agree with Mr. Jaretski that the prescriptions and prohibitions in the Investment Company Act proved beneficial to the industry. I submit that a key factor to the industry flourishing to an estimated $10.6 trillion in assets under management is because the Act was tailored to aggressively eliminate the potential for abuse. Among other things, the Investment Company Act includes minimum capital requirements for companies, prohibits complex capital structures, and prohibits opportunities for “self-dealing” by affiliates. Perhaps even more important is the fact that the Act has been enforced for decades — and that has served to provide a framework for the fund industry that investors and market participants can rely on. The fact that millions of Americans are invested in mutual funds demonstrates the confidence that they have in the fund industry. I believe that a key factor in investors fueling the growth of the industry is that they have had confidence that their assets will be subject to appropriate safeguards. Can you imagine if Congress had enacted the Investment Company Act of 1940 and it was not enforced by the SEC either due to lack of will and/or lack of funds? What would have happened to investor confidence? Where would the fund industry be?

Appropriate Regulatory Construct for Reform

I, for one, remain optimistic about the on-going discussions of fundamental regulatory reform taking place on Capital Hill. I am hopeful that Congress will soon close many of the regulatory gaps that have been painfully highlighted and that it will set the SEC on more solid footing by giving us the ability to have the resources necessary to oversee the Commission’s ever-expanding responsibilities.

Since coming to the Commission, I have been a vocal advocate for the Commission’s mission to protect investors, provide for fair and orderly markets, and promote capital formation. All aspects of this mission guide my thoughts as we consider the appropriate framework to regulate the investment management industry.

Currently, the regulatory landscape in the investment management industry faces potentially dramatic changes from a number of initiatives — including proposals targeting money market funds, investment advisers with custody of assets, and pay-to-play arrangements. In addition, there remain a number of proposals that the Commission has not acted on for the past several years. These include topics as diverse as 12b-1 fees, ETFs, soft dollars, and Form ADV, just to name a few. Moreover, there are discussions that could dramatically impact the industry — from treating all service providers who render investment advice as fiduciaries, to strengthening oversight of advisers, to bringing advisers of pooled funds, such as hedge funds, into the regulatory environment.

As we look to the regulatory proposals on the table and those to come, I think it is vital that each proposal be rigorously analyzed and that the following threshold questions, where applicable, be asked and answered satisfactorily.

  • How does this proposal enhance investor protection?
  • Does this proposal promote a fair and orderly marketplace?
  • Does this proposal prepare for unforeseen developments?
  • Is this proposal sustainable over time? Are the requirements in the proposal accompanied by appropriate funding?

Because we have limited time today and there are so many reforms under consideration, I am going to discuss just a few reforms in the investment management arena that illustrate this analysis.

Enhance Investor Protection and Promote Fair and Orderly Markets

Clarifying that Broker-Dealers who Provide Investment Advice are Fiduciaries

Much has been written and spoken, including by me, about the discussions under way about broker-dealers who provide investment advice. Investment advisers have long been recognized to be fiduciaries and, in fact, actively hold themselves out as such. It has been heartening to see that both the Obama Administration in its White Paper, as well as Congressman Kanjorski in the legislation that he introduced last week explicitly state that broker-dealers who provide investment advice should be treated as fiduciaries. Having this codified in legislation will be helpful.

This proposal furthers investor protection in several ways. Up front, the burden will be on the broker-dealer, just as it now is on the investment adviser, to actively put the client’s interest above his or her own and to affirmatively eliminate or mitigate any possible conflicts of interest. A fiduciary standard provides certainty to investors that the person sitting across the table must provide advice that is transparent and in their best interest. You often hear that investors are confused about who is providing them with investment advice, whether it is an adviser or a broker-dealer. The confusion masks the real danger — which is that investors may receive advice and not understand that the broker-dealer or its registered representative did not have the high standard of a fiduciary duty to put their interests first and to disclose certain conflicts.

By extending the fiduciary standard to broker-dealers who provide investment advice, Congress would reduce regulatory arbitrage, and this would allow for consistent regulatory oversight of the same conduct. Moreover, it would enhance the ability of the Commission to enforce this standard going forward. It also would establish a principle focused on how a business interacts with investors, rather than on how a business may be organized — whether as a broker-dealer or investment adviser.

Removal of NRSRO References

Next I would like to touch briefly on the topic of credit rating agencies subject to Commission oversight, known as nationally recognized statistical rating organizations, or NRSROs. Late last year and more recently, in September, the Commission adopted a number of new rules to enhance the regulatory framework for NRSROs and promote transparency, accountability and competition. However, in addition to these new rules, there are also a number of proposals outstanding — including whether to remove NRSRO references from all of the Commission’s rules. Proponents of the removal believe that there is too much reliance on NRSROs and that it is in the interests of investors to remove all NRSRO references from the SEC’s rules. Many others believe, however, that the use of an objective, external evaluation by a properly regulated NRSRO provides protection — and that the better way to resolve concerns about credit ratings is to improve the reliability of the ratings themselves, not merely remove them.

Removing NRSRO references from SEC rules sounds simple in concept but, in execution, it is much more complex. The fundamental question one has to ask relative to each reference is . . . what role does it have within a given rule? Sometimes the use of an NRSRO reference is simply administrative convenience. But, quite often, the answer is investor protection. It needs to be appreciated that many of the rules containing NRSRO references are exemptive in nature — meaning that the rule allows market participants to engage in activity that would otherwise be unlawful. As just one example, many of the Investment Company Act rules containing NRSRO references allow a fund to operate in ways that it otherwise could not. In most of the rules in question, the rating references often function as a condition designed to permit particular conduct — conduct that would otherwise be prohibited, while at the same time preventing possible abuses that could arise from the conduct.

Given that ratings often serve as an investor protection, one has to look hard to understand whether the reference to a credit rating in a rule has a viable alternative that offers equivalent protection, or whether the exemption itself should be rescinded if the reference is removed.

One approach to ratings that has worked well is the one currently used in Rule 2a-7 under the Investment Company Act. In Rule 2a-7, the credit rating sets a floor for the quality of a security but then, in addition, there is a requirement of an internal evaluation. In particular, the Commission, in its recent proposal, is seeking comment on whether Investment Company Act Rules 3a-7 and 5b-3, and Advisers Act Rule 206(3)-3T should do just this by replacing the ratings standard with alternate standards that would (i) use credit ratings as a minimum standard and (ii) require an additional internal determination of credit quality. This approach could reduce undue reliance on ratings by requiring an additional evaluation of credit quality, while retaining the external or objective measure of the NRSRO rating. It is a belt-and-suspenders approach that can benefit the industry — and more importantly, protect investors.


In addition to asking how a proposal impacts on investor protection, we also need to ask how a proposal impacts the promotion of a fair and orderly market. For example, the Commission recently issued a proposal to address investment advisers who make political contributions in order to be chosen to manage public pension fund money — or, in other words, whether the adviser is engaging in a “pay-to-play” arrangement. This is a proposal that addresses investor protection but is also designed to promote a fair and orderly marketplace.

As we discussed earlier, it is well-recognized that investment advisers owe their clients a fiduciary duty to put their clients’ interests above their own. Investment advisers, who seek to win pension business through political contributions, rather than through their qualifications, are violating their fiduciary duty to the plan and its beneficiaries.

Let’s face it — if an adviser wins business because it has “paid” in order to “play,” there are serious doubts as to whether the most qualified adviser was selected for the job. After all, in such a case, the adviser selection process would not appear to be based on merit and qualification. If the best person was not selected for the job, the plan could suffer inferior management that may lead to greater losses. The plan may also be paying higher fees because the adviser may be trying to recoup its political contributions or because the contract negotiations were not exactly arms-length.

The hope with this rule proposal is that, if it is appropriately crafted and tailored, it will benefit both individual investors in pension plans as well as the market as a whole. By prohibiting an adviser’s ability to enhance his or her chances of being hired through inappropriate political contributions, the goal is that all advisers — large and small — will be able to more effectively compete for a slice of the public pension fund business. The focus of any Commission action in this area should ensure that the emphasis is on choosing the most qualified adviser who is best able to fulfill the needs of pension plans and their beneficiaries.

Being Prepared for Unforeseen Developments

With reform proposals, it is important to solve the problem of today but it is just as important to also build a structure that prepares for the crisis of tomorrow. We can see that the drafters of the securities laws did this by granting the Commission significant discretion to promulgate rules, issue exemptions, as well as investigate and enforce the laws. No one in 1940 would have contemplated that we would have a fund industry worth $10.6 trillion. It is my belief that that the regulatory structure created in 1940 has served investors well by providing a legal and regulatory platform for this industry that has allowed innovations but has also simultaneously fostered investor confidence. This has been a key to the industry’s explosive growth.

One area where I fear that the Commission may miss an opportunity to have the flexibility to prepare for the future is in the hedge fund arena. Because it is difficult, if not impossible, to predict today what rules will be required in the future to protect investors and obtain sufficient transparency, especially in an industry as dynamic and creative as hedge funds, the Commission should be actively seeking from Congress broader authority to have additional regulatory flexibility to act in the future. For example, Congress could provide the SEC rule-making authority to condition the use by a hedge fund of the exceptions provided by sections 3(c)(1) and 3(c)(7) of the Investment Company Act. These conditions could enable the Commission to impose those requirements that the Commission believes are necessary or appropriate to protect investors and enhance transparency. This would grant the Commission flexibility to better discharge its responsibilities and to adapt to future market conditions without having to ask Congress for more authority.

Granting the SEC the authority to condition 3(c)(1) and 3(c)(7) to better and more quickly deal with unforeseen events would be wise policy. The SEC has historically used the power to grant and condition exemptions in a responsible and pragmatic way. As those in this room know, money market funds and exchange traded funds would not exist today if not for the SEC’s use of its exemptive authority.

Making Reform Proposals Sustainable by Specifying Resources

Let me now discuss one of the keys to success in regulatory reform. As the discussion of regulatory reform continues it is crucial that efforts be made to ensure that proper resources are made available. Reform proposals must be sustainable over the long haul — and, simply stated, unfunded regulatory mandates will not be. With approximately 3,600 staff, the SEC is currently responsible for approximately 12,000 public companies; 11,300 investment advisers; 950 fund complexes; 5,500 broker-dealers (with over 173,000 branch offices); 600 transfer agents; 11 exchanges; 5 clearing agencies; 10 credit rating agencies; a number of SROs; and, in addition, has oversight over the nation’s financial accounting standards setter, the FASB. When you compare our responsibility with other regulators you can appreciate how understaffed we are. For example, the FDIC had a staff of 5,000 to oversee 5,100 FDIC-insured banks. Without a doubt, you can see that the SEC staff has its hands full.

If we are to have sustainable reforms, the SEC must receive the appropriate staff and technology funding resources to be able to build and execute a strong regulatory program. Otherwise, the reforms are destined to fail and investors and the market will bear the costs of that failure.

It is my belief that the best way to have a viable SEC is to provide it with the ability to budget and self-fund its operations. The SEC needs to be in the position to set multi-year budgets and respond in real time to drastically changing markets, while also maintaining appropriate staffing. Currently, the SEC’s budget is recommended by the President and annually appropriated and apportioned. Consequently, we do not know from year-to-year what funding level will be appropriated. This structure has harmed the agency’s ability to perform its mission in terms of long-range planning, developing necessary technology and maintaining appropriate staffing levels.

It is important for everyone to realize it is not just the amount of resources that is important, but also the timing of when those resources are received. In my fourteen months as a Commissioner, the agency and the markets have experienced the worst economic crisis in decades. In response, while the SEC is engaged in some restructuring, most notably in our Division of Enforcement, there is much more that should be done. As I travel the country, I meet people who assume that the agency is responding to the crisis by engaging in radical hiring, re-structuring, and the acquisition of state-of-the-art technology. People are shocked to find out that the agency has not done any of these things in any significant way — simply because it can not. We just do not have the resources.

Since taking my oath as a Commissioner, I have been a passionate advocate for the SEC to be self-funded. Basically, as soon as I arrived at the Commission, it became apparent to me that the SEC’s technology infrastructure and strategic planning capacity were threadbare in large part because of how the SEC is funded. This was highlighted when I attended a staff demonstration of surveillance technology that was clearly in serious need of updating and was shocked to learn of the difficulties that the staff was having in getting it updated. In fact, the system had to be taken off line for almost a year — simply because the SEC did not receive enough funding. I believe the American public deserves better.

I have been heartened by the supportive statements made by Senator Schumer and Congressman Kanjorski that the SEC should be self-funded. As Congress contemplates the Consumer Financial Protection Agency as a self-funded entity, I ask that it apply the same principle to the SEC. Being self-funded would put the SEC on the same financial footing as the FDIC, the Federal Reserve, and other financial regulators.

The details of the exact funding mechanism would need to be worked out and there are several possible options including the SEC retaining the registration and securities transaction fees currently collected. These fees currently go directly to the Treasury and have generally exceeded the SEC’s budget by a significant amount. I have seen some press discussions containing some misconceptions about the possibility of SEC self-funding — particularly the idea that penalties could be used as part of the funding process. I have been clear on this, but let me repeat myself. I would never contemplate penalties collected as a result of the SEC’s enforcement actions as a source of funding. The penalty amounts are best served by being returned to investors or by going straight to the Treasury.

Let me also clear up another misconception. Being self-funded will not mean that the SEC would have unfettered discretion. Like other self-funded agencies, the SEC would still be subject to rigorous oversight by Congress. Moreover, it would still be subject to audits by the Government Accountability Office, and its own Inspector General. Additionally, the Office of Management and Budget, the Office of Personnel Management, and the General Services Administration all would continue to conduct oversight over the SEC’s management practices, in areas such as procurement, information technology, human resources, and financial management. On top of all of this, the SEC would still be required to publish its strategic plan and to chart its progress against specific performance measures.

The issue of funding is also particularly acute because the SEC’s responsibilities may be about to significantly grow. Currently, Congress is contemplating expanding the SEC’s jurisdiction to include hedge fund advisers and over-the-counter derivatives, among others. Taking the hedge fund industry alone, the SEC will need to build staff expertise and increase its staff, as well as make significant investments in technology. Just granting the SEC authority over hedge fund advisers is helpful but without coupling the authority with resources it will not result in sustainable reform. For example, three years ago, Congress legislatively directed the SEC to oversee credit rating agencies. However, this grant of authority was not accompanied by a grant of dedicated rulemaking, investigative, and enforcement staff or funding for technology. Basically, the SEC was asked to do a lot more with the same or less overall resources.

Future reforms are destined to fail if no provision is made to accompany the reform with the resources that the Commission needs to make the reform sustainable.


Regulatory reform is upon us. The hope is that we do it in a smart and effective manner. To that end, I encourage all of you to get involved. After all, you are the ones in the trenches — the ones doing the work and the ones that understand what will — and will not — work. Bring your voices to the debate.

In conclusion, I am confident that regulation of the investment management industry can be done right — in a way that balances the needs of the industry with the needs of investors and the needs of the market. 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.


[1] President Barack Obama, Remarks by the President to a Joint Session of Congress on Health Care, September 9, 2009, see
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[2] Jaretski, Alfred, “The Investment Company Act of 1940,” Washington University Law Quarterly (April 1941) pg. 311.
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