Challenges for the New SEC Commissioners

Transcription

1 Challenges for the New SEC Commissioners By Roberta S. Karmel June 20, 2013 The leadership of the Securities and Exchange Commission (SEC) is turning over. A new chairman has been installed and two new commissioners will be on board soon. Many senior staff member positions also have changed hands. At this time the agency has an enormous rule-making workload and serious policy decisions to make. Further, it is operating in a very difficult political environment. This column will outline some of the most important challenges facing the SEC at this time. Mary Jo White was sworn in as the 31st chairman of the SEC on April 10, Because of her background and stellar reputation as a former U.S. attorney for the Southern District of New York, her nomination was viewed as a signal for a tougher line against Wall Street wrongdoing. But because of her previous position as head of the litigation department at Debevoise & Plimpton and a director of NASDAQ, some questioned her ability to restore the SEC's reputation, which had been tarnished by the agency's failure to stop the fraud at Bernard Madoff's investment firm or to prevent the 2008 failure of Lehman and other brokerage firms. 1 Under former Chairman Mary Schapiro, the SEC reorganized its enforcement division and brought numerous high-profile insider trading cases in order to rehabilitate the agency. Although insider trading prosecutions are continuing, in my opinion, these are not the most important investor protection cases. It was refreshing to hear that White is considering focusing on accounting and financial reporting fraud. 2 Nevertheless, the primary challenges facing the SEC today are not in the enforcement arena. Rather, the SEC must deal with its mandated rule-making agenda under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and the Jumpstart Our Business Startups (JOBS) Act; the formulation of policies on market structure and the regulation of money market funds and other pooled investment vehicles; and interaction with other domestic regulators and foreign regulators. In addition, the new chairman will have to maneuver through the partisanship at play in Washington (and even at the SEC) that has led to the agency being buffeted by conflicting congressional demands and internal policy disagreements. Such conflicts can be seen in the difference between Dodd-Frank and the JOBS Act, the former being a heavily regulatory overlay on the financial industry, coupled with some industrial policy initiatives for public companies, and the latter being an effort to deregulate underwritings and the 1

2 responsibilities of new public companies. Both statutes had rule-making deadlines that have not been met by the SEC. Rule-Making, Policy Agendas Dodd-Frank required the SEC to adopt more than 90 new rules relating to such diverse matters as regulation of swaps and certain other over-the-counter derivatives; corporate governance and disclosure; regulation of private investment advisers; regulation of credit rating agencies; municipal securities disclosure; and whistleblowers. The commission has adopted about threequarters of the new rules mandated by the statute, and in addition has completed a myriad of studies required by the statute. Yet, some difficult rule-making remains to be done, much of it in a cooperative effort with other regulators, particularly the Commodity Futures Trading Commission. The complicated and controversial Volcker rule prohibiting banks from proprietary trading and hedge fund investment has yet to be passed. This rule contains many exceptions and needs to be agreed upon by five different regulatory agencies, including the SEC. The JOBS Act does not contain as many rule-making mandates, but it and other pending deregulatory bills in the House 3 suggest some big policy issues for the SEC to consider. In particular, the SEC probably should overhaul its rules regarding solicitations in offerings and also consider one disclosure regime for large public companies and an alternative regime for other issuers in the public securities markets. Such a reconsideration of the SEC's regulation of offerings and public company disclosures would be a much greater undertaking than writing the now overdue JOBS Act rules. Nevertheless, these are tasks that should be undertaken by the new commission. The commission led by Schapiro had many split decisions on important rule-making initiatives, which led to rules being challenged by the Business Roundtable, the U.S. Chamber of Commerce and others and then being vacated by the U.S. Court of Appeals for the D.C. Circuit. Further, in the case of money market fund reform, Schapiro was unable to garner a majority in favor of a rule proposal, leading to the threat by the Financial Stability Oversight Commission to propose its own rule. 4 Two new commissioners have now been nominated to fill anticipated vacancies, one Democrat and one Republican, both congressional staffers. Hopefully, White will be able to forge compromises on new rule proposals and other matters so that the agency can move forward with its rulemaking and policy agendas. The recent promulgation of proposed rules on money market funds, put out unanimously by the commission, seems an excellent beginning to greater accord on important issues. Dodd-Frank was an ambitious effort to prevent another 2008 financial meltdown and bailout of large financial institutions. Nevertheless, it did not address basic problems in the financial sector or its regulation and it did not anticipate future systemic issues. The regulation of money market funds was not addressed. Neither was high frequency trading nor the extreme fragmentation of the trading markets. Congress asked the SEC, in the JOBS Act, to re-examine decimalization, in order to determine the effect of a penny tick size on small and mid-cap companies. The SEC held a roundtable on this subject, but proposed no rules. Neither Congress nor the 2

3 SEC has come to grips with the question of how the public trading markets should now be structured or regulated. Cost-Benefit Analysis A serious impediment to new rule-making is the need for the SEC to formulate a costbenefit analysis for new regulations according to the directions of the D.C. Circuit and legislation that has passed the House and been referred to the Senate. For many years, the SEC resisted making a serious cost-benefit analysis in its rulemaking on the grounds that as an independent federal agency it was not required to comply with executive orders requiring such an analysis. Furthermore, since the SEC consisted primarily of lawyers, rather than economists, the agency did not have the expertise necessary for this task. In addition, there was a question as to how the benefits of investor protection or confidence in the securities markets could be quantified and weighed against the estimated costs of compliance with new rules, cost estimates which could best be made by regulated entities with a conflict of interest. The requirement for a cost-benefit analysis in agency rule-making has persisted through Democratic and Republican administrations. 5 Although the SEC has sometimes resisted compliance with relevant executive and Office of Management and Budget (OMB) requirements because it is an independent agency, Schapiro has stated that the SEC was complying with such executive orders. In any event, the D.C. Circuit has imposed such a requirement on the SEC in several important cases. In Business Roundtable v. SEC 6 the court struck down the SEC's proxy access rule because the SEC "inconsistently and opportunistically framed the costs and benefits of the rule." 7 In particular, the court found that the SEC acted arbitrarily and capriciously for failing adequately to assess the economic effects of its proxy access rule because the agency failed to appreciate the intensity with which issuers would oppose nominees pursuant to Rule 14a-11 and did not adequately assess the costs and frequency of election contests that would result. Very importantly, the court also asserted that the SEC acted arbitrarily and capriciously by failing to consider how union and state pension funds might utilize Rule 14a-11 to gain concessions unrelated to shareholder value. The Business Roundtable case followed two other precedents in which SEC rules were vacated due to inadequate cost-benefit analyses. In American Equity Investment Life Insurance v. SEC 8 the court agreed with the SEC's determination that fixed indexed annuities were securities, but then vacated the SEC's regulation of this product because the commission "failed to properly consider the costs mutual funds would incur in order to comply with the conditions" of the new regulation. In Chamber of Commerce v. SEC 9 the court vacated a rule requiring the chairman of a mutual fund to be independent because the SEC failed to "adequately consider the costs mutual funds would incur in order to comply" with the new regulation. Pending Challenges to Rules While there has been some debate as to whether the same cost-benefit requirements apply to rules mandated by new statutes such as Dodd-Frank or the JOBS Act as apply to new rules initiated by the SEC on its own, there are already pending challenges to two rules under Dodd-Frank. American Petroleum Institute v. SEC 10 is challenging the disclosure of mine safety by 3

4 extractive industries, and National Association of Manufacturers v. SEC 11 is challenging the disclosure of conflict minerals usage by all public companies. These disclosure rules, mandated by Dodd- Frank, are really matters of industrial policy that have little to do with the objectives of Dodd-Frank or investor protection. Yet, the SEC had little choice but to devote resources to formulating these regulations. The mine safety and conflict minerals disclosure rules, 12 the yet to be finalized Volcker rule, and some of the corporate governance reforms of the Sarbanes-Oxley Act and Dodd-Frank have led to push-back by House Republicans in the form of the JOBS Act relieving new public companies from certain securities law obligations and a pending bill imposing stringent cost-benefit analyses upon the SEC in its rule-making. 13 This bill goes much farther than requiring the SEC to assess the costs and benefits of an intended regulation. A new mandate of considering the impact on investor choice, market liquidity in the securities markets and small business would be added to the SEC's existing mandates. A review of existing regulations would be required not later than one year after the enactment of this bill into law and every five years thereafter to determine whether any such regulations are "outmoded, ineffective, insufficient, or excessively burdensome," and then such regulations would have to be "streamlined, expanded, or repealed in accordance with such review." To underline the concern regarding small business, this review would particularly require the SEC to consider the burdens of certain provisions of the Sarbanes-Oxley Act of 2002 to public companies with a float of $250 million or less. 14 Foreign Issuers Another serious challenge for the SEC is how to regulate foreign issuers and how to coordinate domestic and foreign regulation. In Morrison v. National Australia Bank, 15 the Supreme Court discarded more than 40 years of precedent in the lower courts applying the conduct and effects test to cross-border disputes arising under Section 10(b) of the Securities Exchange Act of 1934 and substituted a new transactional test limiting Section 10(b) to frauds "in connection with the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States." 16 Almost simultaneously, Congress provided in Dodd-Frank that the SEC had jurisdiction in such enforcement cases, 17 but since the court held that the securities laws do not apply extraterritorially and so subject matter jurisdiction was not the issue, it is unclear whether Dodd-Frank reversed Morrison as to the SEC or not. Further, the implications of Morrison for SEC rule-making under the Securities Act of 1933 are also unclear. In a global marketplace, the SEC's authority over foreign issuers and cross-border securities transactions should not be so ambiguous. The SEC has been attempting to formulate a policy of "substituted compliance" for some cross-border regulatory problems, but the success of this effort remains to be seen. Also confronting the commission is the problem of whether or not to adopt International Financial Reporting Standards for U.S. companies in lieu of U.S. Generally Accepted Accounting Principles. 18 4

5 Reexamining the Mission How is the SEC supposed to deal with the conflicting mandates and messages it is receiving from a divided Congress and the enormous breath and complexity of its rule writing and policy agendas? I believe that one of the challenges confronting the current SEC is a reexamination of its basic mission. The SEC generally presents itself as the investors' advocate and justifies its regulations in the name of investor protection. But the composition of investors in today's securities markets is complex. Should the SEC be protecting the individual retail investor, who generally is investing indirectly through mutual or pension funds, or should the SEC be protecting such institutional investors? Do institutional investors need more regulation and less protection? Although the SEC's mandate for many years was to act for the protection of investors and in the public interest, in the 1990s this mandate was amended. The SEC also is required to promote "efficiency, competition, and capital formation." 19 Although the SEC under Schapiro formed a new Division of Risk, Strategy, and Financial Innovation, and hired financial economists and other experts to staff this division, changing the SEC's outlook remains difficult. Some commentators believe that the emphasis on cost-benefit analysis is a political maneuver by an activist judiciary and Republican congressmen to halt or overturn all regulation, and the SEC Regulatory Accountability Act passed by the House lends some credence to this view, but it would be a mistake for the SEC to adopt such a stance. The heart of the SEC's mission is capital formation and the purpose of investor protection is to promote strong capital markets. Nevertheless, since so many Americans have their savings invested in the securities markets, directly or more generally indirectly, the SEC cannot abandon its role in regulating public companies and financial intermediaries for the protection of investors. With such a heavy rule-making agenda before it, the SEC should not be forced by Congress or the courts to justify every rule in rigidly defined economic terms. This kind of an overlay on SEC rule-making would lead to agency ossification. Nevertheless, the SEC should consider whether its regulations are an undue burden on capital formation. Roberta S. Karmel is Centennial Professor of Law and codirector of the Dennis J. Block Center for the Study of International Business Law at Brooklyn Law School. She is a former commissioner of the Securities and Exchange Commission. Endnotes: 1. See Shahien Nasiripour, "Obama's Choice to Head SEC Faces Tough Scrutiny," Fin. Times, Jan. 29, 2013, at 3; Tom Braithwaite and Kara Scannell, "Schapiro Leaves Much Unfinished Business," Fin. Times, Nov. 27, 2012, at See Yin Wilczek, "SEC Mulling Whether to Do More in Accounting Fraud, Arena, Chairman Says," 45 Sec. Reg. & L. Rept. (Bloomberg BNA) 1064 ( June 3, 2013). 3. See Richard Hill, "Chamber, Allies Express Support For Pro-Business Bills; Union Pans Measure," 45 Sec. Reg. & L. Rept. (Bloomberg BNA) 1035 (June 3, 2013). 5

6 4. See Roberta S. Karmel, "Is Money Market Reform Finally Coming?" NYLJ, Feb. 21, 2013, at See Exec. Order No. 12,866, 58 Fed. Reg. 51,735 (Sept. 30, 1993); Exec. Order No. 13,563, 76 Fed. Reg (Jan. 18, 2011) F.3d 1133 (D.C. Cir. 2011). 7. Id. at F.3d 166, (D.C. Cir. 2010) F.3d 133, 136 (D.C. Cir. 2005). 10. No (D.D.C. Oct. 10, 2012). 11. No (D.C. Cir. Jan. 16, 2013). This case has now been transferred to the D.C. district court. 12. The conflict minerals disclosure rules require public companies to report on whether they are using certain minerals from the Democratic Republic of the Congo or an adjoining country in their product, and if so to conduct certain audit procedures. The objective of these rules is to halt certain human rights violations in the Congo and has little to do with investor protection. 6