Regulatory Reform in the Obama Era
By Peter J. Chepucavage and Tony Broy
Senator Jack Reed, a Democrat and Chairman of the Senate Subcommittee on Securities, said last Thursday that he will hold a hearing to review the Securities and Exchange Commission (SEC) from top to bottom and see where improvements can be made and would call in experts to offer recommendations. While there may well be benefits to this effort, it will also slow down any internal efforts by the commission to restructure.
We offer the following as a temporary solution that can be implemented without legislation:
REGULATION BY ENFORCEMENT IS NOT WISE
Expectations are high for serious reform and much of that expectation suggests merely hiring more SEC Enforcement staff. But as explained in the U.S. Chamber of Commerce's Center for Capital Markets Competitiveness' Report: Examining the Efficiency and Effectiveness of the U.S. Securities and Exchange Commission (February 2009) (CCM Report)http://www.uschamber.com/assets/ccmc/090211ccmc_sec_speed.pdf, enforcement should not be the primary venue for implementing policy. By its very nature, enforcement staff pursue sanctions after the fact, but that, in itself, poses a problem because the SEC must not always be reactive. The former SEC Enforcement Director admitted as much during congressional hearings. Enforcement staff do not perform surveillance or examine. A wiser approach or strategy to prevent problems is through an increase in preventative staff or better use of current resources. Harry Markopolis made the same point in his Congressional testimony.
ALLOCATION OF RESOURCES IS VITAL
There are currently at least six entities regulating the securities side of financial services. The SEC has 3,500 employees. The Financial Industry Regulatory Authority (FINRA) has 3,000 employees. The New York Stock Exchange (NYSE) regulatory staff has approximately 300-500 employees and the NASDAQ regulatory staff has additional personnel. The 50 states have approximately 500-700 employees in their securities administrator's offices and attorney general's offices. The Federal Reserve Board has employees overseeing the bank holding companies that include Wall Street's biggest firms. Each of these entities overlaps in some ways. However each distinguishes examinations and surveillance from enforcement. We believe there is a natural allocation of duties that could change the current culture of racking up notches by sticking it to the small firms. We recommend a loose federation of regulators working together toward a common goal. We will address broker-dealers but a similar approach is applicable to Investment Advisers.
BIG FIRMS AND SMALL FIRMS
There are 550 Securities Industry and Financial Markets Association (SIFMA) members who we classify as big firms and another 4400 registered broker-dealers that we classify as small firms. However, there are really about 10- 20 firms accounting for most of the broker-dealer investment banking business. We think a natural allocation of responsibility would be as follows:
THE STATES:Without giving up any big firm responsibility, the States would be primarily responsible for examining the small firms. They would share all results with both FINRA and the SEC. If necessary, the Congress could allocate funds to states for additional resources. If desired the states could refer cases upward that are too complex or resource heavy.
The North American State Securities Administrators Association (NASAA) recently echoed these sentiments as follows in its NASAA's Core Principles for Regulatory Reform in Financial Services:http://www.nasaa.org/issues___answers/legislative_activity/9775.cfm
Our system of financial services regulation must be improved to better protect our investors, our markets, and our economy as a whole. To serve all of these vital interests, Congress and the Administration, working together with federal regulators, state regulators, and self-regulatory organizations, should take steps to ensure that our new approach is strong, comprehensive, collaborative, and efficient. We can achieve these objectives by applying five core principles for regulatory reform.
PRESERVE OUR SYSTEM OF STATE/FEDERAL COLLABORATION WHILE STREAMLINING WHERE POSSIBLE. Regulating our financial markets is an enormous challenge, one that can only be met through the combined efforts of state and federal regulators, working together to protect the integrity of the marketplace and to shield consumers from fraud and abuse. We must resist attempts to weaken this collaborative system. State securities regulators, for example, must not be preempted or marginalized as mere advisers to federal authorities. Particularly in the areas of enforcement, licensing, and compliance examinations, state regulators provide indispensable consumer protections. At the same time, we should look for opportunities within this collaborative framework to make regulation more streamlined and efficient. . . .
FINRA AND THE SEC:FINRA would take responsibility for the SIFMA firms including sole responsibility for Broker-dealer activities.
- The SEC would transform its BD role to that of adviser and overseer of FINRA. It would give up broker-dealer cases and instead accompany FINRA on its exams and advise it on its enforcement proceedings. It would become the equivalent of military advisers. It would focus its real enforcement efforts on those cases such as insider trading that require subpoena power for other non-regulated entities. It would maintain offices at FINRA the way the FED does at big banks. Its relationship to the states would be one of friendly consultation with the ability to step in if a state needs assistance
- The SEC would not be judged by cases brought or fines imposed. It would be judged by the amount of fraud prevented. The fewer the frauds, the better job being done. An enforcement case after a fraud is needed but preventing a fraud is much more valuable. Regulation by numbers of cases or exams is a distortion of regulation. SEC employees would remain free to join either FINRA or the private sector, but the chairman would have authority to pay large retention compensation. Former SEC employees would not be allowed to intervene at the director level as was alleged in the Aguirre matter except by written argument and with the staff present. Nor should they be allowed to meet privately with the commission on rulemaking. Access to commissioners is important but that access must be open and above board.
- The current Office of Compliance Inspections and Exams (OCIE) would move to the New York, Chicago, Boston, Miami and Los Angeles regional offices but would report directly to the Division of Trading and Markets in Washington. The regional directors would report to the head of Enforcement for all matters. It has been our experience that the delineation of responsibility between the regional offices and OCIE and the divisions has been confusing. The CCM REPORT confirms this.
The CCM report recommends as follows:
Recommendation 1—The Division of Trading and Markets and the Division of Investment Management should be realigned into a Division of Investor Protection and Retail Financial Services Regulation and a Division of Market Oversight and Operations. The Examination Programs of the Office of Compliance, Inspections, and Examinations (OCIE) should be assigned to these new divisions.
(See Page 4 of the CCM Report).
. . .
When OCIE was created, it was envisioned that a separate unit devoted to examinations would provide greater visibility. It was also thought that a merger of the two autonomous examination programs would create synergies and improve efficiency. While the first goal, greater visibility, has been achieved, there is disagreement on the hoped-for synergies.
More important, there have been deleterious unintended consequences. The separation of the on-site examinations staff from the regulatory policy divisions has deprived these divisions of critical real-time information. As one former division director commented, “The division has lost its eyes and ears. I used to be able to read an article in the Wall Street Journal in the morning and have an examination team from the New York office onsite in the afternoon. That’s no longer possible.” Today, it is more likely that information from an examination will be the basis for a formal order of investigation. While this may be appropriate in many instances, it is another reflection of the shift at the SEC from a “regulatory compliance” paradigm to a “regulation by enforcement” paradigm.
(See Page 12-13 of the CCM Report)
- Traffic ticket violations may be one way to avoid the waste of time on small violations. We believe the staff should have the ability to settle small cases up to a limit without ever having to go to the commission. These cases can be reviewed after the fact to insure against abusive staff conduct. A quick settlement for a small fine is far preferable to an extended proceeding involving significant legal fees, which are impossible for small firms."
- The FED and its NY bank would assume responsibility for all OTC derivatives and all financial instruments not carried in a broker-dealer. The FED should be able to form task forces when jurisdiction crosses product lines.
INTELLIGENCE GATHERING AND WHISTLEBLOWERS
We do not believe the word "risk" should be used to describe financial fraud and prefer the word "intelligence" or "counter-intelligence." Risk should be confined to assessing leverage and financial stability. We agree with much of what Markopolos had to say about examination techniques as follows:
- More market experienced and older examiners including financial markets economists and technology experts as per the CCM Report.
- Complete freedom for examiners when entering a firm to roam and talk.
- Up-to-date analytical tools.
Our last thought concerns whistleblowers and the gathering of intelligence. We have no easy answer but we offer some areas of development:
- These functions must be centered in New York and the other big cities.
- Individuals must have Street experience and access to high-level Street personnel and they may well be undercover.
- Whistle blowers have to be triaged to handle the important ones and it may well be that this function is outsourced to a private investigative entity to quickly detect the Markopolos caliber informants.
- There must be a pipeline to the gatekeepers in the firms where they can be protected and encouraged to talk matters over without fear. In this sense they must have some whistle-blower protection.
Congress needs a better oversight vehicle then the Government Accounting Office (GAO). The SEC staff knows the GAO has no authority and treats their findings accordingly. The oversight vehicle must have the ability to actively make changes at the SEC and FINRA including personnel and policy changes similar to the recommendations recently made by the SEC'S inspector general. Most specifically the committee would oversee the corporate governance of FINRA to insure the equal treatment and representation of all firms.About the Author:
Peter J. ChepucavagePlexus Consulting Group, LLC1620 Eye Street, NWSuite 210Washington, DC 20006Phone: 1.202-785-8940Fax: 1.202-785-8949Email: email@example.com
has 30 years of experience in both the public and private sectors of the securities industry. He has worked for the National Association of Securities Dealers (NASD) and U.S. Securities and Exchange Commission (SEC), as well as a private law firm and a major international investment bank. He is familiar with all aspects of broker-dealer and hedge fund regulation, including broker dealer operations and stock loans.
Chepucavage was also heavily involved in the post-9/11 efforts by the securities industry to strengthen their resilience to terrorist attacks. He is a General Counsel to the firm and the head of its broker-dealer/hedge fund compliance and expert testimony sections.
Chepucavage most recently worked as an Attorney Fellow in the SEC's Division of Market Regulation where his main projects were post-9/11 resiliency and short sales, including the drafting of Reg. SHO. Prior to his position at the SEC, he practiced at Fulbright & Jaworski in New York city. At various times between 1984-1997, he was a managing director in charge of Nomura Securities' legal, compliance and audit functions and served on its management and credit committees. He also worked with its derivatives' affiliate.
Mr. Chepucavage has been a member of many Securities Industry Association (SIA) and other regulatory and legal securities industry committees and written extensively about regulation. One of his main interests is the effect of regulation on small businesses and he provides regulatory advice to small and medium enterprises, including Washington representation. Mr. Chepucavage also served as an Assistant General counsel with the NASD, a law clerk to Judge George R. Gallagher (D.C. Court of Appeals), and as an infantry officer in South Korea.
Peter Chepucavage is also a member of the advisory board of The Public Company Management Corporation (OTCBB:PUBC), an emerging company providing consulting and advising services to companies seeking to access public capital markets.
has almost 40 years experience as both an NASD examiner and very successful market-maker. He cares deeply about the survival of self-regulation.
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