Regulators Working Together to Serve Investors

Luis A. Aguilar is a Commissioner at the U.S. Securities and Exchange Commission. This post is based on Commissioner Aguilar’s recent remarks at the North American Securities Administrators Association Annual NASAA/SEC 19(d) Conference; the full text, including footnotes, is available here. The views expressed in the post are those of Commissioner Aguilar and do not necessarily reflect those of the Securities and Exchange Commission, the other Commissioners, or the Staff.

It is my honor to deliver the opening remarks for today’s [April 14, 2015] North American Securities Administrators Association (“NASAA”) and Securities and Exchange Commission (“SEC”) 19(d) Conference. For those who are keeping count, this is my seventh year as the SEC’s liaison to NASAA. It has been a privilege to serve you in this role, which I have done since my early days as a Commissioner. Before I begin my remarks, however, let me issue the standard disclaimer that the views I express today are my own, and do not necessarily reflect the views of the SEC, my fellow Commissioners, or members of the staff.

NASAA and the SEC have a long history of working together to provide a robust regulatory environment for businesses to grow and to protect the investors who fuel that growth. Today is a clear example of that partnership, where representatives from the SEC and state regulators come together to share ideas for increasing cooperation and collaboration. This partnership is crucial to achieving our common goal of protecting investors, maintaining market integrity, and facilitating capital formation.

I will start by taking a few moments to highlight some of the great work in our continuing battle against fraud. Here are a few examples of what the states have done, as reflected in NASAA’s 2014 Enforcement Report:

  • State securities regulators received more than 9,600 complaints from aggrieved investors and conducted more than 5,300 investigations;
  • States undertook about 2,200 administrative, civil, and criminal enforcement actions involving more than 3,000 respondents and defendants;
  • States reported criminal actions that resulted in more than 1,800 years of incarceration—the highest in the last five years—and more than 670 years of probation; and
  • States imposed more than $600 million in investor restitution orders, and monetary fines and penalties of more than $70 million.

The SEC enforcement staff has also been busy. In Fiscal Year 2014, the SEC received about 16,000 tips and complaints from investors; opened more than 1,000 investigations; commenced more than 670 civil and administrative actions; worked with criminal authorities to file more than 120 criminal cases; and obtained more than $2.7 billion in disgorgement and almost $1.4 billion in penalties.

In particular, and a topic I’d like to discuss today, the SEC has been active in the structured and new products area. In Fiscal Year 2014, the SEC brought a number of enforcement actions involving complex financial instruments, several of which were handled by a specialized enforcement unit—the SEC’s Complex Financial Instruments Unit (“CFI”). These cases included enforcement actions relating to subprime mortgage-backed securities offerings, disclosures in collateralized debt obligations, and the sale of residential mortgage-backed securities. In addition, earlier this year, the SEC brought a fraud action against the credit rating agency Standard & Poor’s for misconduct relating to its rating of certain complex commercial mortgage-backed securities, and for hiding critical information from investors.

Currently, the CFI unit is focusing on structured and new products sold to retail investors, and the Commission expects future enforcement cases in this space. Relatedly, the SEC’s examination priorities for 2015 will focus on, among other things, registrants that develop new structured products and offer them to retail investors.

I note that NASAA is also concerned about so-called “new products.” In fact, a key enforcement trend cited in NASAA’s 2014 report points to the risks of “new products,” such as digital currencies like Bitcoin, being touted through classic fraudulent schemes. This focus is appropriate. Indeed, an investor’s constant quest for the next big thing plays right into the hands of fraudsters, who often use the complexity of new products to hide their schemes.

The fraud and abuse connected to these “new products” is particularly troubling, in light of the ongoing need to improve investors’ readiness and their ability to spot the danger signs of risky investments. This need is not a new development. A 2012 SEC staff study on investor financial literacy found that retail investors—particularly the elderly and minorities—lack basic financial literacy skills. Although there have been some efforts over the years to address investor financial literacy, we are still nowhere near where we should be. This is particularly troublesome, as investment products are becoming more complex and harder to understand.

To address these issues, the Commission and NASAA must continue its partnership to serve and protect investors. To this end, strong communication between us is crucial. State securities regulators are often the first to receive tips and complaints from harmed investors and the first to identify fraudulent conduct occurring within their local jurisdictions. We need to make sure that our communication is effective and ongoing, so the SEC staff can be alerted to new and developing scams and frauds. Of course, this needs to be a two-way communication.

Similarly, the Commission and NASAA members would both benefit from greater collaboration in implementing the Commission’s rules. State securities regulators have extensive experience in working closely with issuers and investors. This experience and expertise provide NASAA members with an important perspective that would be beneficial to the SEC. In addition, greater collaboration and cooperation would enable NASAA members, among other things, to have better insights into Commission rulemakings, policies, or activities that impact local jurisdictions. By ensuring that the Commission and state regulators work closely together, we can ensure a win-win situation for both investors and our capital markets.

Our mutual collaboration will make our capital markets safer and more vibrant, and ensure that it remains the envy of the world.

Today, I will focus on two areas:

  • First, the need for the Commission and state regulators to focus on combating fraud involving complex securities—including structured securities sold to retail investors; and
  • Second, the need for the Commission to cooperate and collaborate with state regulators to implement the Regulation A amendments of the JOBS Act, and to work together in other areas where our responsibilities overlap.

The Risks Posed by Complex Securities to Retail Investors

In determining how to invest their money, investors face a bewildering array of options. Indeed, given the low interest environment that’s been prevalent these past years, many investors may feel that their savings and investments do not provide sufficient “upside potential” toward meeting their financial goals, such as paying for college, buying a home, and planning for retirement. As a result, they are more likely to chase yield by buying investments touting higher returns. However, oftentimes, these investment products can be very opaque and complex for retail investors to fully appreciate the risks involved. Unfortunately, as NASAA has pointed out, yield-starved investors become easy prey for fraudulent schemes that are cloaked as investments in complex securities.

Complex securities are difficult to define because they vary widely depending on the nature of their underlying securities and/or the complexity of their trading strategies. In general, however, “complex securities” refer to securities that often involve embedded derivatives and may include equity-indexed annuities, leveraged and inverse exchange-traded funds (ETFs), principal protected notes, and reverse convertibles. Complex securities can also include exchange-traded products, or ETPs, and alternative mutual funds. The difficulty in defining the exact contours of what constitutes a complex security also makes it difficult to ascertain the size of the market. One thing is clear, however, complex securities have been increasingly marketed to retail investors in recent years. To give you some idea about the characteristics of the complex securities market, here are some data on ETPs and the alternative mutual fund market:

  • First, the total asset growth of ETPs in the U.S. rose to more than $2 trillion in March 2015. Historically, retail investors and their advisers hold an estimated 50% of ETP assets in the U.S.
  • Second, the alternative mutual fund market grew from about $76 billion in assets at the end of 2009 to over $311 billion in assets at the end of 2014. The growth of this market was fueled by the growing interest in the retail market.

These data points indicate that the retail market for complex securities will continue to grow in the years to come.

Now let’s talk about one particular type of complex security known as structured notes—which has now become a $45 billion market—and where the registered offerings are targeted at retail investors. In fact, recent data shows that an estimated 99% of all purchasers of these products are retail investors. These securities are issued by large financial institutions and offer returns that are linked to the performance of a reference asset or index. In their most basic form, structured notes are investment products that typically have a fixed maturity that includes a bond component and an embedded derivative. What isn’t always made clear are the risks of these debt look-alikes—of which there can be many. As the SEC recently pointed out in an Investor Bulletin, the risks of these products include, among others, the products’ complex payoff structures, market risk on the reference asset or index, high fees, a lack of a liquid secondary market, opaque pricing, credit risk, and complicated payoff structures that can make it difficult to assess value, risk, and potential for growth. Moreover, there are a wide variety of structured notes that have different risk profiles—some of these examples include principal protected notes, reverse convertible notes, enhanced participation or leveraged notes, and hybrid notes that combine multiple characteristics.

Structured notes grabbed widespread public notoriety in 2008 when Lehman Brothers filed the biggest bankruptcy in U.S. history. Lehman Brothers had sold unsecured debt called “principal protected notes” that became worthless when the firm collapsed, and investors lost billions of dollars as a result. In essence, the securities sold as “principal protected” were really not “protected;” in fact, the “protection” that was offered was tied to the creditworthiness of the issuer, which cratered along with Lehman Brothers. These products have been referred to as “Trojan horses” that ultimately enter into an investment portfolio and destroy people’s life savings.

A year after the market crash, the number of issuances for structured notes fell by more than 1,200 issuances and their value decreased by $4 billion—from 7,217 issuances worth about $38 billion in 2008 to 5,933 issuances worth about $34 billion in 2009. The market has since bounced back with ferocity, however. In 2014, structured notes reached 10,732 issuances valued at more than $45 billion.

Because these products may be difficult to understand and can pose great risks to retail investors, they warrant more regulatory attention. In fact, the SEC staff has increased its focus on improving disclosure with respect to structured notes by requiring enhanced disclosures of pricing and valuation at the time of issuance of structured notes. In 2013, for example, letters requesting additional disclosures were sent to several issuers, including nine of the most active issuers of structured notes. Moreover, the Division of Corporation Finance has an office called the Office of Capital Markets Trends that has led interdivisional efforts—including the Division of Enforcement, the Division of Trading and Markets, and the Office of Compliance Inspections and Examinations—to specifically look at issues relating to structured notes.

Notwithstanding these focused efforts on structured notes, investor advocates have questioned whether the Commission has done enough to disclose the risks of these products. They have also questioned whether the current disclosure regime is enough to address the risks associated with complex investment products. The concern raised is whether understanding these products requires an investor to “understand concepts that either make no sense or are so complex that they require the knowledge and sophistication of a highly trained financial professional to understand them.”

These concerns are valid and deeply troubling. A bedrock principle of the federal securities laws is that issuers must be prepared to disclose all material risks presented by their securities in a way that investors can understand. Complex products that lack such disclosures run counter to this principle. That’s particularly true when the products are targeted to retail investors.

To this end, although the staff has focused on structured notes, there is more that can be done as to the complex securities market in general. For example, there are two steps the Commission could take right away to address this market more broadly. First, the SEC staff needs to expand its focus on structured note disclosures to include all complex securities sold to retail investors. Second, the SEC staff should not go it alone and would benefit by formally adding both NASAA and FINRA as full partners in this effort. NASAA members and FINRA have extensive experience with complex products and can provide valuable insights into how these securities are being marketed to retail investors and how to ensure investors are protected.

The protection of retail investors is paramount and demands immediate attention.

Enhancing the Partnership between State Regulators and the SEC

Next, I want to discuss how the SEC and NASAA members can work together more effectively. Shortly after I became a Commissioner and realized how limited our resources were, I considered ways that we could increase collaboration and cooperation between the SEC and NASAA. Specifically, in early 2009—in fact at the NASAA Winter Enforcement Conference on January 10, 2009—I raised the possibility of embedding a NASAA representative at the SEC. In my view, having someone at the SEC would provide the states with an unfiltered view into the Commission’s activities. In addition, a NASAA representative could also provide the Commission with a real-time voice regarding the states’ perspective on a number of important issues. For a variety of reasons, the idea did not get traction back in 2009, and, like many good ideas, was overtaken by the demand of other priorities. However, I had never forgotten that idea, and recently found an opportunity to again start the dialogue.

That opportunity came with the recent amendments to Regulation A.

Regulation A has been a longstanding exemptive regime under the Federal securities law that allows companies to raise capital without all of the costs of full registration, so long as they provide the investing public with certain critical disclosures about the company and the securities being offered. The Regulation A amendments recently adopted by the Commission, commonly known as “Regulation A-plus,” made several significant changes to this regime, including increasing the dollar amount that can be raised from $5 million to $50 million. Specifically, the new rules created two tiers of issuances that provide a higher ceiling for use of the Regulation A registration exemption: “Tier 1” for securities offerings of up to $20 million in any 12-month period; and “Tier 2” for offerings of up to $50 million in the same period.

The path from proposing stage to adoption involved the difficult issue of state preemption. As you know, at the proposing stage, the Commission proposed to preempt the application of certain state blue sky requirements with respect to all offerees in Regulation A offerings, including both Tier 1 and Tier 2 offerings, and all purchasers in Tier 2 offerings. In addition, the proposed amendments capped Tier 1 offerings at $5 million.

While the Commission ultimately preempted state registration and qualification requirements for Tier 2 offerings, the adopting rules provide the states with a greater role than what was contemplated in the proposal. First, unlike the proposed rules, the Commission did not preempt state review as to Tier 1 offerees. Moreover, at my suggestion, the Commission raised the Tier 1 offering ceiling from $5 million to $20 million. I greatly appreciate Commissioner Piwowar’s support in this effort, as well as the rest of the Commissioners who voted unanimously to support it.

Furthermore, as under the proposed amendments, the adopted rules give the states a chance to preview Tier 2 offerings. Under the adopted rules, first time Regulation A-plus issuers must publicly file their offering statements with the Commission at least 21 days before qualification. This will allow the states to require issuers to file such material with them for a minimum of 21 calendar days before any potential sales occur to investors in their respective states.

Moreover, as was always the case, state regulators retain the powers to investigate and bring antifraud enforcement actions involving Regulation A-plus issuers, or against any broker-dealers involved in unlawful conduct in a Regulation A-plus transaction.

Nonetheless, because the use of Regulation A is divided between those involving the states’ review process in Tier 1 and those that do not in Tier 2, the regulation of these offerings provides a challenge. Clearly, fraud in Tier 2 offerings will still land on a state regulator’s doorstep. As a result, I explored ways that the SEC and NASAA could increase communication and provide NASAA with insight into the SEC’s activities. To that end, I reintroduced the idea that I first had back in 2009—to allow a NASAA representative to be embedded at the SEC. I found a receptive audience with Chair White, and this idea is now being pursued. Specifically, the SEC and NASAA are in discussions to assign a state representative to the SEC to be involved in the staff’s assessment of Regulation A-plus offerings. This arrangement will provide the SEC staff with the benefit of the experience that state regulators have in reviewing the offerings of the smaller companies expected to use Regulation A-plus.

In addition, I believe that a state regulator representative embedded in the SEC can go a long way to providing a bridge between Tier 1 and Tier 2 offerings and provide the states with a holistic view of issuers using Regulation A-plus. This should provide enormous benefits for both the state securities regulators and the Commission. I hope that we’re able to finalize this arrangement before the Regulation A amendments go into effect.

In my view, having a state regulator representative as part of the review team will create synergies that will go well beyond Regulation A-plus and, hopefully, will broaden over time into other areas. Indeed, I believe we should also explore having a state regulator representative embedded with the SEC’s Division of Enforcement.


To conclude, I want to highlight the tremendous efforts of the staffs of the SEC and the NASAA members in protecting investors. I am proud to be part of this group of hardworking public servants. I appreciate your efforts in continuing the good fight on behalf of our nation’s investors.

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