Speech by SEC Commissioner:
Remarks Before the Financial Services Roundtable Lawyers Council 2007 Spring Meeting
by
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
Washington, D.C.
May 10, 2007
Thank you, Steve, for that kind introduction. It is an honor to be part of your spring meeting. Before I begin, I must note that the views that I express today are my own and do not necessarily reflect those of the SEC or my fellow Commissioners.
Even after all these years in the financial services industry, I never cease to be amazed at the constant innovation in the industry. The pace of change has only quickened as new technologies open new possibilities. Money flows from one corner of the world to another with ease. Even something as fundamental as customer interaction has changed radically. Email has replaced phone calls and the internet has displaced first-class mail and faxes. Products and services that could not even have been conceived of a decade ago are in great demand today. The variety and complexity of financial products continue to grow. Products and services that once were the province of the wealthy few now make routine appearances in the portfolios of all sorts of people. All of this innovation means that the financial services industry is serving more people than ever before and doing a better job of meeting their needs.
As breathtaking as these changes have been, one has to acknowledge that the legal and regulatory environment has affected the course that innovation has taken. Laws, of course, provide the solid framework without which innovation would not be as likely to happen at such a rapid rate. Protection of property rights, enforcement of contracts, impartial application of transparent rules - all the things that we commonly call the rule of law - give people confidence to invest their money with people with whom they do not have a personal relationship.
Peruvian economist Hernando de Soto in his book The Mystery of Capital discusses the importance of a strong system of property ownership.1 We often take it for granted, but the recognition and protection of contract and property rights by the government and courts is a central achievement of economically developed countries. Just think about it: our system of credit, mortgages, securities, derivatives, and all the securitized instruments that have developed during the past twenty years are built on a standardized, transparent system that evidences clear title to property and enforceability of contractual terms. The predictability and transparency allows others to see and assign an arm's length value to the property. This clarity facilitates trading and allows owners, in Dr. de Soto's words, to "unlock" the value inherent in their capital.
It is not that less developed countries are necessarily poor. They have plenty of entrepreneurial spirit and in fact a lot of capital. It is just that this capital is "dead," in Dr. de Soto's words. It cannot be tapped by the owners to realize the full value of their property. Thus, the owners have to rely on family, friends, and the informal economy to finance their businesses. Without the rule of law and transparency of assets, it is difficult for people to enter into transactions with unfamiliar people or property - to minimize risk, they will deal only with those whom they know and trust. The risk, and thus the cost, to them of doing otherwise may prove to be prohibitive. This protective economy is necessarily more constrained and less liquid than a more open alternative.
Behind every system of property rights, of course, there has to be a system that protects and vindicates those rights. A vigilant, honest, predictable policeman certainly contributes to investor confidence. In a system that is perceived to be relatively honest, transaction costs are lower than they are when extensive due diligence is required before routine financial transactions. The risks of investing are lower too. Alan Greenspan noted the particular importance of regulation in the securities markets: "Lax supervision may suffice in some kinds of markets, but stands little chance of succeeding in financial markets which rely so heavily on confidence and trust and the supporting legal infrastructure."2
Accurate, clear disclosure facilitates the development of new products. Good disclosure gives investors a reliable picture of what they are buying and how it complements the rest of their portfolio. Audits by independent third-parties allow absentee owners to keep track of how their property is being managed by their employees and agents and to hold those agents accountable for performance. Internal compliance programs and routine inspections of those programs contribute to investors' confidence that firms have mechanisms in place to foster lawful behavior and prevent unlawful behavior. An enforcement program that pursues firms and individuals that knowingly violate the law further adds to investor confidence. A well-balanced regulatory environment also gives people an incentive to innovate because they know that they will be able to reap the rewards of doing so.
On the other hand, poorly crafted regulations and careless regulators can upset a well-functioning market. As Treasury Secretary Henry Paulson observed recently, "Excessive regulation slows innovation, imposes needless costs on investors, and stifles competitiveness and job creation."3 Regulatory compliance can divert resources that otherwise would have been spent on innovation. Even in a disclosure-based system, regulators may find it difficult to resist the urge to engage in merit regulation. Investors, as a consequence, may have to settle for a product or service that is not perfectly-suited to meet their needs. Existing firms in the industry may purposefully influence regulation to their advantage and their competitors' disadvantage. As a result, other firms in the industry or potential new entrants to the industry might be shut out.
Regulatory uncertainty can dampen innovation. Arbitrariness in enforcement of regulations is one source of uncertainty. It imposes costs of random and unpredictable magnitude. Even an enforcement investigation that is ultimately abandoned without charges can impose tremendous costs. Indeed, the Commission many decades ago was so concerned about this issue that our Canon of Ethics contains the following, timeless warning: "The power to investigate carries with it the power to defame and destroy." Peter Wallison and Cameron Smith, in a 2005 white paper that was sponsored by the Financial Services Roundtable, made the sobering observation that "enforcement activities now make [the SEC] in a very real sense a participant in the securities market as well as a regulator."4
New products may be stifled because they do not fit within a pre-existing regulatory bucket. They may run into a wall of resistance from regulators whose eyes are jaundiced by the constant stream of enforcement cases that they see. Exemptive relief may be available, but perhaps only at great expense and after undue delay. In this fast-moving industry, the cost of elapsed time may be higher than the monetary cost of the exemptive process. Moreover, the arbitrariness of the process can shift someone who was first in line to the back of the line, thus stealing away his first-mover advantage and discouraging innovation.
In a particularly hostile regulatory climate, some firms might go so far as to shun innovation. They may decide that lying low to avoid attracting regulatory scrutiny might appear to be the safest course. A recent report prepared by McKinsey for New York Senator Schumer and New York City Mayor Bloomberg included the results of a survey of senior executives, some of whom believe that "the legal risks associated with being a business trailblazer are starting to undermine America's entrepreneurial culture, which in turn damages its traditional leadership in innovation."5
Ironically, innovation is sometimes a side effect of regulation. As one commentator observed, "the dense regulatory structure … that envelopes much of the financial sector has also been influential in inducing innovation."6 Innovation in that case is inspired by a desire to get around regulatory restrictions and thus is a product of an artificially skewed marketplace with artificial costs imposed by the regulation. Sometimes that innovation can be productive, notwithstanding the costs associated with dealing with the regulation - ETFs, for example. Sometimes, however, that "innovation" can be very destructive - the perversion of SPVs by Enron, for example.
Pondering innovation, regulation, and the intersection of the two can be a useful exercise, particularly for a regulator. Pondering innovation, regulation, and the intersection of the two also can be a painful exercise, particularly for a regulator. This exercise is useful because it encourages regulators to take into account the effects that their actions and inactions have on innovation. This exercise is painful because it causes regulators to see how some of their past actions and inactions have thwarted or distorted innovation. The prospect of the pain sometimes causes regulators to avoid the exercise altogether. But, in the words of every high school coach, "No pain, no gain."
The SEC recently has received considerable encouragement to face the pain and engage in this exercise. As you all know, a number of recent reports on the U.S. capital markets have included observations and recommendations about the SEC. I am grateful for the outside voices that have called on us to undertake a consideration of our regulations. These calls are coming from people who appreciate the work that the SEC does, but know that the SEC could do a better job if it took a more thoughtful approach. I share their optimism that the SEC can modify its regulatory approach and thereby encourage, rather than stifle innovation as it sometimes has done in the past.
One reason that I am optimistic is the progress that the SEC and the Public Company Accounting Oversight Board (PCAOB) are making on overhauling the implementation of Sarbanes-Oxley section 404. Section 404 requires management to complete an annual internal control assessment and requires the company's outside auditor to attest to, and report on, management's assessment. The actual costs of implementing Section 404 have greatly exceeded the anticipated costs. They also have exceeded the benefits. Smaller public companies, many of which are centers of innovation, have been especially hard hit. Many of these companies are high in market capitalization, but low in revenue. They calculate the cost of implementing Section 404 in terms of the number of PhD scientists that they will not be able to hire as a result. Investors, of course, pay for excessive 404 implementation costs not only through higher than necessary audit and consulting fees, but also through constrained growth because of resources diverted to non-productive uses.
Some have dismissed smaller companies' concerns by stating categorically that "If you cannot afford to do a real 404 review, you should not be a public company." Even if that were true, it is not the regulator's determination to make. Rather, regulators ought to do what they can to minimize regulatory burdens without compromising regulatory objectives. Unfortunately, the notion that small firms do not deserve to play in the game if they cannot afford the shiny new equipment that the big firms have is not a new one. I have heard this same argument in response to concerns over regulatory burdens on small mutual funds. It is sometimes instructive to look at the self-interest of those making these kinds of claims.
A better response to the Section 404 implementation problem is the one that the SEC and the PCAOB are in the process of crafting. In December 2006, the SEC proposed additional guidance for management's assessment of internal control. We have sought to provide management with guidance of its own so that their assessments are not driven by the auditors, who have been operating under the PCAOB's much more prescriptive standard. To complement these changes, the PCAOB has proposed a new auditing standard to replace AS2. The proposed standard affords auditors greater room for judgment and employs a risk-based framework to direct their efforts.
Both the SEC and the PCAOB still have work to do to refine the new implementation approach. Some of these issues were highlighted in an open Commission meeting earlier this spring. The many comment letters that we received also are helping us in this process. Among other changes, we are working with the PCAOB to align the new audit standard with our management guidance, to reduce the prescriptiveness of the PCAOB's proposal, to eliminate the unnecessary focus on significant deficiencies, to enhance scalability, and to further facilitate auditors' use of the work of others. Once we have the new approach in place, implementation will be the true determinant of success.
The experience with Section 404 is a reminder that it is better to get things right the first time around. In the face of uncertainty, the SEC too often has exhibited a determination to move forward with extreme haste. Not surprisingly, this course of action only invites trouble. The SEC's actions over the past several years in the fund governance arena are one illustration. All the SEC has to show for its efforts in this area are two adverse court decisions and considerable uncertainty in the industry. Instead, we could have followed an approach suggested by the Financial Services Roundtable in 2004 - ensure clear disclosure and let investors decide what type of governance structure they want.7 This approach would have benefited investors without depriving mutual funds of their flexibility. Former Commissioner Cyndi Glassman and I advocated such an approach without success.
Granted, it is not always possible to anticipate the consequences of regulatory action. In such circumstances, a simple rule of thumb is balance and "think smart." Smart regulation uses economic analysis to balance costs and benefits. Sometimes, this necessarily means to "think small," rather than upend the entire market place for an ill-defined and poorly quantified goal. The SEC, again over my dissent and that of Commissioner Glassman, did just the opposite with Regulation NMS. The SEC's "big thoughts" have caused big problems. Reg. NMS represents a massive regulatory intrusion into our secondary trading markets. This intrusive regulatory approach was undertaken in the absence of evidence of market failure. Substantially less-intrusive means were available to advance its purported goals. Reg. NMS has the potential to do significant harm to our markets by unduly interfering with the operation of competitive forces. Over the years, these forces have benefited investors immensely by reducing trading costs and increasing market efficiency. Reg. NMS is a carte blanche for unsupervised meddling by the SEC staff in the marketplace for years to come.
Reg. NMS consists of the trade-through rule, the access rule, the sub-penny rule, and the market data rules. Some of these rules are much more problematic than others. The most problematic component of Reg. NMS is the trade-through rule. Based on the trade-through studies I read during the rulemaking process, I did not see a need for trade-through "protection." Protection from what? The freedom to choose how you want your trade executed? I doubt that any of you believes that the government knows better than investors how trades should be executed. Perhaps the rule actually "protects" us from innovation. One need only look at the precedent for this sort of rule - the SRO/ITS trade-through rule - to see that the only thing "protected" by the rule was an outdated market structure. Market participants did not need protection - the duty of best execution, coupled with the rise of electronic trading centers, would have ensured that investors got satisfactory executions. So I am sorry to report that now - despite the fact that competition has driven the manual markets to automate - we will soon have a trade-through rule and at the same time no assurance of best execution compliance for orders sent to some of these automated markets.
The implementation process for Reg. NMS has been and will continue to be a challenge. We have granted extensions of the trade-through rule and market access rules - which together are the heart of NMS. The original implementation date was June 29, 2006, almost one year ago. The difficulty in the creation of new, electronic trading systems by the exchanges was undoubtedly one reason for the extensions. In truth, however, the unduly complex and burdensome nature of the rules themselves made the extensions necessary. I expect that the implementation problems are not over, but I will continue to work to ensure that the rules are implemented in a way that minimizes their potential harm.
I hope that my fears are not realized and that the harm caused by Reg. NMS will be limited to the millions of hours and dollars spent on implementation. The real consequences for our markets, however, will not be known for years, after the damage has been done and after trading patterns have shifted in unpredictable and irreversible ways and perhaps to other venues. In any event, the creative energy poured into working through the implementation difficulties could have been better spent on finding ways to better serve the marketplace.
Yet other SEC initiatives continue to inspire hope. One such initiative is a recently concluded experiment by our Office of Economic Analysis in connection with short sales. For many years, academics had been questioning whether the SEC's short sale price test, or "tick test," was needed. The tick test, which has been on the books for seven decades, restricts the prices at which short sales may be executed. The SEC's economists conducted a pilot test on approximately 1,000 securities to see whether removing the price tests would make stocks more susceptible to patterns associated with downward manipulation. They did not find evidence to suggest that pilot stocks are more likely to be manipulated downward than other stocks. Based on the results of the pilot, the Commission proposed last December to eliminate the tick test across the board. I commend the staff's careful approach.
We owe it to the financial services industry and the investors that you serve to take a consistently careful approach to regulation. Regulatory unpredictability undermines innovation and growth. One ongoing issue brings the importance of predictability to mind. On March 30, the D.C. Federal Circuit Court of Appeals rejected an SEC rule that excepted from the Advisers Act broker-dealers providing advice that is solely incidental to brokerage, but charging an asset-based or fixed fee for its services. Unlike the other recent decisions affecting mutual funds and hedge funds, this was a split decision. The Court found that the SEC had exceeded its authority, but the dissenting judge found the SEC's interpretation of the Advisers Act to be "a reasonable interpretation of an ambiguous statute."
I certainly think that the SEC would be well justified to ask for this ruling to be heard by the full DC Circuit - unlike the other vacated rules, this rule was adopted by a unanimous Commission. At the very least, as an interim measure, we need to ask the Court for a stay to allow for an orderly transition and appropriate rulemaking consistent with the Court's decision. Otherwise, I am afraid of confusion in the marketplace. Now that many firms have shifted customers into fee-based accounts in reliance on our actions -- and, one could argue, at our strong urging -- we should be striving to provide as much certainty as is in our power to provide to affected investors.
In the longer term, bigger questions are at issue and will have to be resolved. There are strong feelings about where and how to draw appropriate lines between broker-dealer and investment advisory activities and regulatory regimes. The SEC recognized the difficult questions in this area and their far-reaching importance at the time it adopted the rule. Indeed, the adopting release announced that the staff would undertake a further examination of the broker-dealer and investment advisor regulatory regimes. Last September, the SEC commissioned the RAND Corporation to do the fact-gathering and empirical research that will form the basis for the SEC's next steps in this area. RAND is looking at how financial products and services are marketed, sold, and delivered to retail investors. The study will investigate, among other things, how financial professionals are compensated and what investor perceptions are. This study will provide the raw material for the SEC's further action in the area. Ultimately, it is probably Congress that should resolve this issue of uncertainty between two sixty-year-old statutes governing an area that has changed so much over that time.
Another way in which the SEC can foster innovation, rather than hinder it, is to work with foreign regulators. International cooperation is becoming increasingly important as our markets become increasingly international. If the SEC exhibits a cooperative spirit, the American financial services industry is likely to enjoy the fruits of a reciprocal spirit of cooperation. The SEC is making great strides in this respect. One example is the progress that we are making towards eliminating the requirement that foreign private issuers that prepare their financial statements using International Financial Reporting (IFRS) Standards do not have to reconcile them to U.S. GAAP. Significantly, the SEC will also consider whether to allow U.S. issuers to use IFRS. Another recent example of the SEC's international efforts is the rules that we adopted in March to make it easier for foreign companies to exit U.S. markets.
By making it easier for foreign companies to leave the U.S. markets, the SEC has also made it easier to judge how our regulations are affecting the markets. If we see foreign companies leaving in droves, we will have to ask ourselves whether our regulations are playing a role in their departure. We may conclude that companies are leaving for other reasons, but even asking the question will benefit the U.S. marketplace.
Thank you all for your attention. I look forward to hearing your thoughts now and in the future. My door is always open and your ideas on what the SEC is doing well and what it can do better are always welcome.
Endnotes
http://www.sec.gov/news/speech/2007/spch051007psa.htm
