SEC COMMISSIONER GALLAGHER'S REMARKS AT ROCKY MOUNTAIN SECURITIES CONFERENCE

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

Remarks at the 46th Annual Rocky Mountain Securities Conference

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Commissioner Daniel M. Gallagher

Denver, CO

May 9, 2014

Thank you, Julie [Lutz], for that kind introduction. I’m very pleased to be here today, and I’m proud to say that this will be my fourth time addressing this conference, the last three as a Commissioner. I am always happy to visit Denver, in large part given the presence of a key SEC regional office here. I am a big supporter of our regional offices, and I am very pleased to report that yesterday I made good on my oath to visit all of our offices when I made it to Fort Worth. Now I will try to pull off second visits before the end of my term.

* * *

Despite the onslaught of regulation over the past ten years and the consistency with which extremely costly and often frivolous plaintiff actions are brought, our capital markets continue to be the strongest and most vibrant in the world. As the primary U.S. capital markets regulator, the SEC administers a regulatory framework built upon our threefold mandate to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation.

Consistent with that framework, industry professionals such as registered representatives of broker-dealers and investment advisors are required by law to be licensed or registered and to subject themselves to the regulatory oversight, examination, and reporting requirements of the federal securities laws. In other words, we require market professionals, particularly those who interact with retail investors, to apply for, and prove themselves worthy of, the privilege of working in the industry.

Unfortunately, this privilege is all too often abused by scoundrels, including some that repeatedly engage in egregious misconduct that directly impacts retail “mom and pop” investors, destroying their nest eggs and financial security. These repeat offenders, despite accumulating dozens of customer complaints and disciplinary actions, have been able to remain in the industry by jumping from one disreputable firm to another and hiding behind false and misleading CRD filings and Form BD representations. They are, to be blunt, cockroaches, and it is in all of our interests to purge them from our markets.

This is, of course, not a new problem. After all, capital markets are risk-taking markets, and unfortunately a risk as old and as certain as time is that where there is opportunity, there will be unscrupulous characters trying to take advantage of the unwary. The SEC has been struggling for decades to find the best approach to rooting out recidivist misconduct by the worst of the bad apples, but unfortunately, there are no easy answers.

Illustrating this point, exactly 20 years ago this month, the SEC released a report in conjunction with the NASD and NYSE called the “Large Firm Project” that reviewed the hiring, retention, and supervisory practices of nine of the country’s largest broker dealers, which at the time were responsible for handling approximately 50% of all public customer securities accounts in the United States.[1] The report’s findings were grim, reflecting a number of significant concerns about the business activities and conduct of broker-dealers and their registered representatives. Some of the more noteworthy findings may sound depressingly familiar to you.

For example, the study found high turnover rates: over a third of the registered representatives selected as a sample set for the study had left the industry within the two-year examination period, including many who left involuntarily or were barred from the industry altogether.

It also reflected a high incidence of potential enforcement violations, with fully 25% of exams leading to enforcement referrals. The study showed that bad actors are concentrated in select firms: three of the nine firms examined accounted for 88% of the study group’s enforcement referrals. The study also revealed numerous findings of inadequate supervision. Perhaps most concerning is the fact that these bad actors were able to move between firms freely after customers registered complaints.

Do these findings—now two decades old—sound familiar to you? The sad truth is that these are exactly the same types of behavioral red flags we still see today. Only two months ago, for example, the Wall Street Journal reported the results of a study finding that more than 1,500 broker-dealer registered representatives had failed to report bankruptcy filings in their CRD disclosures, while over 150 had failed to report criminal charges or convictions.[2] In response, FINRA announced that it would perform a comprehensive vetting of public disclosures for the more than 600,000 investment professionals it oversees—brokers, not investment advisors—against public court records. FINRA will also propose rules requiring employee background checks.[3]

I recently asked staff in the Office of Compliance, Inspections, and Examinations to put together some statistics based on disclosure information submitted by broker-dealer registered representatives on FINRA’s BrokerCheck system. The results are eye-opening.

An astounding 20% of the 600,000 plus actively licensed registered representatives have between one and five disclosures for items such as customer complaints, regulatory violations, terminations, bankruptcy, judgments, and liens. One active—and currently employed—registered rep has disclosed a whopping 96 customer complaints and disputes. Another individual has made 21 financial disclosures relating to bankruptcies, yet still is licensed and working in the industry. At the firm level, 17% of broker-dealers had more than six total disclosures, and 5% had more than 20 disclosures.

These numbers illustrate a real and growing problem in the securities industry. These repeat offenders are swindling seniors out of their hard-earned retirement funds, looting our kids’ custodial accounts, and diverting assets from charities and religious organizations. But despite our best efforts, they manage to stay in the industry and continue to wreak havoc on the investing public.

I would be remiss if I did not point out that a common misconception is that this is exclusively or even primarily a broker-dealer problem rather than an investment adviser problem as well. In reality, there are plenty of repeat offenders at investment advisory firms who are engaging in misconduct. We’re just not finding them as quickly because the SEC allocates a disproportionate amount of resources to policing the activities of broker-dealers when compared to those we expend policing investment advisers. There are nearly three times as many investment advisors registered with the SEC than there are broker dealers: approximately 11,100 investment advisors versus about 4,300 broker-dealers. This is due in large part to unfunded mandates imposed upon the SEC by Title IV of Dodd-Frank. Even more importantly in the context of resource allocation, there is no SRO interposed between the adviser industry and the SEC like there is for broker-dealers.

I worry that this has created the unfortunate side effect of underreported investment advisor rule violations, inappropriately skewing our enforcement statistics by revealing a disproportionate amount of problems on the broker-dealer side. Simply put, it is impossible to separate the fact that we find many more broker-dealer violations than investment advisor violations from the fact that thanks to the assistance of the SROs, we examine a greater proportion of broker-dealers than investment advisors.

One way to address this imbalance would be to provide for third party examiners of investment advisors—including, potentially, defining the term “third party” to include SROs in order to allow the SROs currently involved in broker-dealer oversight to conduct examinations of “dual hatted” investment advisors as well.[4] In the past, questions regarding the wisdom of creating an SRO for investment advisors have been addressed in a binary sense: should the Commission push Congress to create an SRO for investment advisors, or keep things as they are? Leveraging the current resources and expertise of broker-dealer SROs to assist in investment advisor examinations could greatly facilitate our ability to examine advisors without undertaking the daunting project, with Congress, of creating a new investment advisor SRO out of whole cloth.

Regardless of how we do so, enhancing our ability to examine investment advisors would also serve the critical purpose of allowing us to have informed deliberations on Section 913 of Dodd-Frank Act. Section 913, as you may know, authorized, but did not require, the Commission to adopt rules establishing a duty of care for brokers-dealers that is no less stringent than that which applies to investment advisors and to undertake further efforts to harmonize the two regulatory regimes.[5]

Mind you, as with so many Dodd-Frank requirements, Section 913 has absolutely nothing to do with the financial crisis, but as we proved in the case of conflict mineral disclosure, that may not dissuade the Commission from pursuing a rulemaking. Indeed, it is becoming painfully obvious that many special interest groups and members of the Administration believe this is a terrific election year issue to pursue. As an independent agency, the SEC should never be persuaded by such political forces.

And, although many in Washington seem to have concluded after the high profile issuance of the Volcker Rule that Dodd-Frank rulemaking is “done,” the Commission still needs to complete almost 60 mandated Dodd-Frank rulemakings. In addition to these rulemakings, which include key elements of Title VII derivatives regulation and the removal of references to credit ratings from Commission rules, the Commission still has significant—and well overdue—work to do on implementing the JOBS Act. And, by the way, we still have eight decades worth of securities laws to administer on a daily basis and critical projects on the horizon such as a much needed holistic equity market structure review, and critical reforms in the fixed income markets, such as the disclosure of riskless principal markups.

In light of this agenda, I question the wisdom of rushing into purely discretionary Section 913 rulemaking, especially when the purported substantive impetus is the potentially false narrative that broker-dealers represent a greater potential threat to retail investors than investment advisors. The truth is that we simply don’t know whether or not that is the case. There have been far too many laws and regulations that stemmed directly from false narratives of the financial crisis and its causes. The Commission should slow down and get all of the facts before adding to the long list of rules resulting from these false narratives.

* * *

So what is the SEC doing to curb the abuses perpetrated by the recidivist bad actors I mentioned, whether on the broker-dealer or investment advisor side? I am pleased to report that in recent years, the agency has made great strides in developing programmatic and technological tools aimed at efficiently ferreting out the most egregious misconduct and identifying those individuals and firms most likely to be recidivists.

Some of the most exciting developments are coming out of OCIE under the able leadership of Drew Bowden. Drew’s dedicated and talented staff has developed a number of innovative tools that have moved the examination program into the 21st Century and enabled the staff to surgically and efficiently zero in on potential abuses.

For example, OCIE’s Risk Assessment and Surveillance group, which is responsible for identifying candidates for examination among registered entities, has developed new analytics to track the migratory patterns of registered representatives. Using public disclosures—including U4 and U5 filings and other data from the SROs—the team can track industry professionals who are hopping from firm to firm and single out firms that appear to be havens for individuals with long rap sheets of customer complaints and disciplinary actions. This targeted approach to risk assessment enables our examiners to immediately identify the statistical outliers who are most likely to engage in misconduct.

OCIE’s boots-on-the-ground examiners also have been deploying a new analytics tool, the National Exam Analytics Program, that allows them to review massive amounts of registrant data in a matter of minutes. Rather than relying on a small sample of activity for a few dozen accounts over a compressed time period, OCIE examiners can import a registrant’s entire trade blotter for multiple years and immediately generate over 50 types of customized reports identifying potential red flags for account churning, excessive commissions, P&L irregularities, suspect asset allocation, front running, and even insider trading.

Complementing these efforts is OCIE’s Risk Analysis Examination initiative, which uses advanced analytics to examine data from the largest clearing firms and broker-dealers to identify potentially problematic trends industry-wide. In 2013 alone, this group reviewed hundreds of millions of transactions by more than 500 firms, including trading data that enables OCIE to target for examination broker-dealer firms that appear to be systematically engaged in high pressure sales tactics and excessive trading. With this data, we are able to zero in on firms that are, in essence, nothing more than a criminal enterprise designed to separate investors from their money.

The best part of the story is that all of these tools were developed in-house by the SEC staff. They have revolutionized the way our teams conduct examinations and have done much to level the playing field in terms of our ability to root out potential misconduct by recidivists.

And, OCIE isn’t the only arm of the agency making progress in this area. Under the strong leadership of Director Andrew Ceresney, the Division of Enforcement has made several programmatic changes that have greatly enhanced the SEC’s efforts in identifying and combatting the worst recidivists.

Perhaps most noteworthy is the creation of a task force late last year, a group near and dear to me, to focus on broker-dealer enforcement issues. Among other initiatives, this new task force will coordinate with OCIE and FINRA to target misconduct by “rogue” registered representatives with prior disciplinary histories or customer complaints.

My hope and expectation is that the task force will complement the work of the two specialty units created by the Division of Enforcement in 2010: the Asset Management Unit, which investigates misconduct by investment advisors, investment companies, and private funds, and the Market Abuse Unit, which focuses on difficult-to-detect frauds in which honest investors are bilked without ever knowing anything is amiss. Working collaboratively both inside and outside of the agency, these groups are making substantial progress in identifying and rooting out misconduct by the worst of the bad actors.

* * *

There is no question that we are making real progress on these issues, but more needs to be done to send a forceful message to the bottom dwellers of the securities industry that their behavior will not be tolerated. As I’ve illustrated today, the SEC has a number of tools to combat abuses by recidivists, but we need to make sure that we are using them in the most efficient manner possible and that the tools we have are sufficient for the task.

Most importantly, the agency needs to take aggressive action aimed at permanently expelling the worst offenders from the securities industry. All too often, we see the same individuals and firms featured prominently in examination reports and enforcement actions. As an agency, we need to seek out the repeat offenders and revoke their licenses and registrations rather than repeatedly mete out injunctions that can be violated and penalties that can be paid from the fruits of misconduct. Unless we put these offenders out of the industry for good, they will continue to take advantage of retail investors.

With respect to the most egregious and recidivist violations of our securities laws and regulations, whether by broker-dealers or investment advisors, we need to ask ourselves a fundamental question: should the violating entity retain the privilege of participating in our capital markets? Unbeknownst to many, both the Exchange Act and the Investment Advisers Act authorize the Commission to deregister entities if it finds such action to be in the public interest, although we have rarely done so.[6] This authority, of course, should only be invoked after full due process has been afforded to the entity in question, but it should indeed be invoked when appropriate. I have seen several instances in which I believe it would be appropriate since I’ve been a Commissioner.

As a federal agency charged with protecting investors, the SEC needs to make such existential threats—and, where appropriate, deliver on them—in the most egregious circumstances. Otherwise, the cockroaches of the industry will continue to abuse the system, shrugging off the well-meaning but all too often ineffective remedial actions taken against them.

* * *

In closing, I want to convey my sincere belief that most of the men and women who work as professionals in the securities industry have proven themselves worthy of that privilege by conducting themselves with honesty and integrity. The unparalleled strength of our capital markets is in large part the product of the work ethic and high moral character of the professionals who work with the millions of individual and institutional investors that participate in those markets.

Unfortunately, the stability, security, and attractiveness of our markets are all too easily tainted by the misconduct of a handful of reprehensible miscreants who abuse the system time and time again. Working as a registered broker-dealer representative or an investment adviser representative, holding a securities license, or operating a securities firm are privileges that carry with them a heavy responsibility, privileges that can and should be taken away in cases of abuse. As an agency, the SEC needs to lead the way in targeting and eradicating the worst offenders from the markets altogether.

Once again, thank you for this opportunity to share my thoughts with you, and I wish you an enjoyable and productive conference.


[1] The Large Firm Project, A Review of Hiring, Retention and Supervisory Practices, Divisions of Market Regulation and Enforcement, United States Securities and Exchange Commission, May 1994, available at http://www.sec.gov/news/studies/rogue.txt.

[2] Regulator Deletes Red Flags From Brokers’ Records, Says Study, Wall St. Jrnl., March 7, 2014, available at http://online.wsj.com/news/articles/SB10001424052702304554004579423270046013550.

[3] Plan to Fix Cracks in Broker Records — Wall Street Regulator to Propose Rules for Background Checks, Measures to Identify Red Flags, Wall St. Jrnl., Apr. 16, 2014, available at http://online.wsj.com/news/articles/SB20001424052702303887804579503653564597512?mg=reno64-wsj%26url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB20001424052702303887804579503653564597512.html.

[4] See Jim Angel, On the Regulation of Investment Advisory Services: Where Do We Go from Here?, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1951991.

[5] Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 913, 124 Stat. 1376, 1824 (2010) (requiring analysis and rulemaking regarding fiduciary obligations of investment advisers and broker-dealers).

[6] See 15 U.S.C. 78o(b)(4) (stating that the Commission “shall . . . revoke the registration of any broker or dealer if it finds . . .[that such] revocation is in the public interest and that such broker or dealer” committed certain actions enumerated in the statute); 15 U.S.C. 80b-3(e) (stating that the Commission “shall . . . revoke the registration of any investment adviser if it finds . . .[that such] revocation is in the public interest and that such investment adviser” committed certain actions enumerated in the statute).

JOINT STATEMENT BY SEC COMMISSIONERS GALLAGHER, PIWOWAR ON CONFLICT MINERALS DECISION

FROM:  SECURITIES AND EXCHANGE COMMISSION 

Joint Statement on the Conflict Minerals Decision

Commissioners Daniel M. Gallagher and Michael S. Piwowar

April 28, 2014

On April 14, 2014, the D.C. Circuit decided that requiring issuers to describe certain of their products as not DRC conflict free violated the First Amendment.[1] It remanded the case to the district court to determine how much of the Commission’s conflict minerals rule is therefore unconstitutional. We believe that the entirety of the rule should be stayed, and no further regulatory obligations should be imposed, pending the outcome of this litigation. Indeed, a stay should have been granted when the litigation commenced in 2012.

A full stay is essential because the district court could (and, in our view, should) determine that the entire rule is invalid.

First, the First Amendment concerns permeate all the required disclosures, not just the listing of products that have not been determined to be DRC conflict free. As the D.C. Circuit noted, an issuer is required “to tell consumers that its products are ethically tainted, even if they only indirectly finance armed groups.”[2] A limited modification to our rule eliminating the requirement to declare certain products as “not DRC conflict free” would fail to fully address the First Amendment violation. For example, the fact that an issuer would still be required to include a description of its due diligence procedures in its reports would suggest that the issuer may have “blood on its hands” for its products since it is sourcing certain minerals from the DRC. Moreover, current staff guidance restricts an issuer from stating that its products are not indirectly financing or benefiting armed groups in the DRC in the absence of a costly independent private sector audit report.[3]

Second, even assuming that the due diligence disclosures standing alone do not implicate First Amendment concerns, we believe that the “name and shame” approach is at the heart of not only the Commission’s rule, but of Section 1502 of the Dodd-Frank Act itself. The disclosures about the due diligence process are not themselves sufficient to achieve the benefits that Congress sought to advance. Rather, it is the listing of products—the apotheosis of the diligence process—that is central to the rule. Thus, disclosures about the due diligence process should not be seen as severable from the unconstitutional scarlet letter of not DRC conflict free.

A finding that the entire rule is invalid, and that the invalidity is rooted in the statute, would permit Congress to reconsider whether Section 1502 achieves the benefits that it was supposed to attain. Unfortunately, the evidence is that it has been profoundly counterproductive, resulting in a de facto embargo on Congolese tin, tantalum, tungsten, and gold, thereby impoverishing approximately a million legitimate miners who cannot sell their products up the supply chain to U.S. companies.[4] Reconsidering Section 1502’s core approach would also save investors billions of dollars in compliance costs,[5] and ease the problem of information overload by eliminating special interest disclosures that are immaterial to investment decisions.

Perhaps the District Court will not ultimately agree with us, and will permit some portion of the Commission’s rule to continue in force. But given the uncertainty, the wisest course of action would be for the Commission to stay the effectiveness of the entire rule until the litigation has concluded. Marching ahead with some portion of the rule that might ultimately be invalidated is a waste of the Commission’s time and resources—far too much of which have been spent on this rule already—and a waste of vast sums of shareholder money. A full stay of the effective and compliance dates of the conflict minerals rule would not fix the damage this rule has already caused, but it would at least stanch some of the bleeding.


[1] Nat’l Ass’n of Mfgrs v. SEC, No. 13-5252 (D.C. Cir. Apr. 14, 2014).

[2] Id. at 20.

[3] Division of Corporation Finance, Frequently Asked Questions on Conflict Minerals, available at http://www.sec.gov/divisions/corpfin/guidance/conflictminerals-faq.htm (Question 15).

[4] See, e.g., The Unintended Consequences of Dodd-Frank’s Conflict Minerals Provision, Hearing before the Subcommittee on Monetary Policy and Trade of the U.S. House Committee on Financial Services, No. 113-23 (May 21, 2013).

[5] The Commission estimated compliance costs at $3–4 billion for initial compliance, and $207–609 million per year thereafter. See Rel. 34-67716, Conflict Minerals (Aug. 22, 2012) at 302.

TRANSCRIPT OF REMARKS BY SEC COMMISSIONER GALLAGHER AT FORUM FOR CORPORATE DIRECTORS, ORANGE COUNTY, CALIFORNIA

FROM:  SECURITIES AND EXCHANGE COMMISSION 
Remarks to the Forum for Corporate Directors, Orange County, California
 Commissioner Daniel M. Gallagher
Forum for Corporate Directors, Orange County, California
Jan. 24, 2014

Thank you, Chris [Cox], for your generous introduction and your invitation to address this truly distinguished gathering.  I was honored that Chris asked me to speak here today.  But it was an even bigger honor to work for Chris when he was Chairman, both as his Counsel and as Deputy Director of the Division of Trading and Markets.  Chris’s incredible intellect and leadership tremendously benefited the agency during the worst of the financial crisis.  I know I can speak for my colleagues who, like me, toiled in the trenches alongside Chris when I say that Chris was an island of calm in a sea of misguided government intervention.

* * *

This morning, I’d like to discuss two issues that, along with a holistic review of equity market structure, should be at the very top of the SEC’s agenda.  The first is the revamping of our corporate disclosure system, and the other is a set of much needed reforms for the proxy advisory industry.  Each of these issues demands our close attention despite the fact that – at the risk of sounding subversive – neither issue was the subject of a congressional mandate to the Commission.  So while these issues are not among the fashionable diversions of the moment, addressing them would be consistent with what I like to call the Commission’s basic “blocking and tackling” mandates.  We have spent far too little time on such core responsibilities over the last four years, and the neglect is evident.

* * *

Let’s begin with disclosure reform.  The SEC is, first and foremost, a disclosure agency.  Our bedrock premise is that public companies should be required to disclose publicly and in a timely fashion the information a person would need in order to make a rational and informed investment decision.  That is the foundation of our securities law regime and the core principle by which we administer those laws.  We can’t protect investors and foster capital formation in fair and efficient capital markets unless critically important information about public companies is routinely and reliably made available to the public.

At the same time, we need to take seriously the question of whether there can be too much disclosure.  Justice Louis Brandeis famously called sunlight the best disinfectant.[1]  No doubt – but, as my friend and former colleague Troy Paredes pointed out some years ago, investors can be “blinded by the light” of information overload.[2]  From an investor’s standpoint, excessive illumination by too much disclosure can have the same effect as inundation and obfuscation — it becomes difficult or impossible to discern what really matters.  More disclosure, in short, may not always yield better disclosure.

* * *

Investors often say that disclosure documents are lengthy, turgid, and internally repetitive.  Today’s mandated disclosure documents are no longer efficient mechanisms for clearly conveying material information to investors, particularly ordinary, individual investors – myself included.  A recent House of Representatives Appropriations Committee report put it like this:

“Voluminous, overly-complex, legalistic and immaterial corporate disclosures both increase investor confusion and discourage shareholder participation in important corporate governance matters.”[3]

The complexity of today’s disclosure requirements give the Commission cause for self-examination.  SEC rules that require periodic corporate reporting, the detailed instructions that implement them, as well as pertinent staff interpretations and guidance, have been the principal forces shaping modern corporate disclosure.  External forces, too, have played a role, most notably the risk of litigation – much of it absolutely frivolous and solely for the benefit of plaintiffs’ lawyers.  When failing to make an anticipatory disclosure can prompt a shareholder lawsuit, it is rational for those who prepare corporate disclosure documents to prepare for the worst.  The result is a perverse incentive to create prolix disclosure documents that are designed primarily to anticipate and defend against shareholder lawsuits rather than to provide intelligible and pertinent information to the average investor.

* * *

So what should we do?  Should we jump in with both feet to begin a comprehensive review and overhaul of SEC-imposed disclosure requirements under the securities laws?  Or should we take a more targeted approach, favoring smaller steps towards our ultimate reforming goals?  Ordinarily, I would argue for a comprehensive approach to solving almost any problem in securities regulation, since actions in one area frequently have unforeseen and unintended effects in others.

Where disclosure reform is concerned, though, I would prefer to address discrete issues now rather than risk spending years preparing an offensive so massive that it may never be launched.  I’ve been gratified to see that Chair White, too, has expressed an interest in disclosure reform,[4] so I hope and expect that, under her stewardship, the Commission can make real headway on this important issue.

Although the Dodd-Frank Act did not mandate disclosure reform, the JOBS Act required the SEC to study Regulation S-K, our fundamental regulation governing non-financial statement corporate disclosure, to determine where its requirements could be updated “to modernize and simplify the registration process and reduce the costs and other burdens associated with” it for emerging growth companies.[5]  The resulting Commission staff report to Congress called for a reevaluation of the Commission’s disclosure requirements “in order to ensure that existing security holders, potential investors and the marketplace are provided with meaningful and … non-duplicative information upon which to base investment and voting decisions, that the information required to be disclosed by reporting companies continues to be material and that the disclosure requirements are flexible enough to adapt to dynamic circumstances.”[6]

The staff report further emphasized that “economic analysis must … inform any reevaluation of disclosure requirements.”[7]  It’s hard to disagree with any of those conclusions.

* * *

So, notwithstanding the approximately sixty – yes, sixty - Dodd-Frank-mandated rules we have yet to complete, it’s my strong belief that it’s time to get started on disclosure reform.  I’d like to share, based in large part on what I’ve heard from market participants, a few examples of some good, practical issues on which the Commission should focus.

One such issue is “layering disclosure” based on the recognition that some information is inherently material, such as a company’s financial statements, while some is not – for example, the pay-ratio calculation required by Dodd-Frank.[8]

Another issue is the need to streamline Form 8-K disclosure.  Does each of the categories of information now required to be disclosed on Form 8-K really require almost immediate disclosure when a change occurs?

I also believe that we should make a targeted effort to reduce redundancy in filings by providing authoritative guidance explicitly telling issuers where they must disclose and where, by contrast, they need not disclose particular types of information. This would enable those looking for that information, including professional analysts and advisers, to find it or identify its absence easily.

Also in the name of reducing redundancy, it’s high time that we gave priority to streamlining proxy statements and registration statements.  Permitting some of the required financial information to be included in an appendix to the proxy, for example all financial tables other than the summary compensation table, would aid both investors and issuers.  As for registration statements, we could permit forward incorporation by reference in Form S-1 registration statements. That would permit a registrant automatically to incorporate reports filed pursuant to the Exchange Act subsequent to the effectiveness of the registration statement.

We also need to renew our focus on the potential of technology to improve corporate disclosure, acknowledging that our present requirements are almost certainly not those we would have devised for today’s technology-enabled world.[9]  Here, I would be remiss if I did not cite data tagging as an investor-empowering analytic tool for ensuring that information is disclosed and presented in a manner that promotes ease of comparison and analysis.  The SEC’s move to data tagging is an innovation for which Chairman Cox deserves the lion’s share of the credit, and it took vision and persistence, not to mention one heck of a terrific staff.  But make no mistake:  we have not come anywhere close to realizing the potential technology holds for improving our disclosure system.

One small way to further integrate technology into our disclosure regime would be to test a standardized, online disclosure system that requires one-time online disclosure of basic corporate information, mandating that it be updated as necessary with changes tracked, rather than rotely repeated each year in annual disclosure documents.

In addition, we could increase the reliability and authoritativeness of SEC disclosure guidance by issuing significant guidance only with the explicit endorsement of the Commission, rather than as staff guidance.  Guidance issued under a Commission imprimatur would allow registrants to feel more confident in relying on it – especially, I’d note, from a litigation standpoint.

We must also recognize politically-motivated disclosure mandates as the ill-advised anomalies they are and, as an independent, bipartisan agency, express our opposition to the use of the securities disclosure regime to advance policy objectives unrelated to providing investors with information material to investment decisions.  Our new Form SD, adopted to implement a pair of wholly social policy mandates,[10] serves as an example of such policy-driven forays.

These are just examples, and I’m sure that all of you could supplement this short list.

* * *

But we can’t stop there.  No discussion of disclosure reform would be complete without addressing the issue of corporate governance – and no discussion of corporate governance would be complete without considering the role of the proxy advisory industry.  I have spoken about this issue repeatedly, and I’ve been glad to see that the subject of proxy advisor reform has, over the past twelve months, been the subject of a Congressional hearing, academic articles, media reports, rulemaking petitions and even, I’m especially happy to say, a recent SEC roundtable.

Proxy advisory firms have gained an outsized role in corporate governance, both in the United States and abroad.  In the United States, I am sorry to say this is largely a result of the unintended consequences of SEC action.  In 2003, the SEC adopted new rules and rule amendments that required an investment adviser exercising voting authority over its clients’ proxies to adopt policies and procedures reasonably designed to ensure that it votes those proxies in the best interests of its clients.[11]  By adopting this rule, the Commission sought to address, among other goals, an investment adviser’s potential conflicts of interest when voting a client’s securities on matters that affected its own interests.  The Commission’s adopting release noted that “an adviser could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendations of an independent third party.”[12]

Proxy advisory firms realized the potential windfall offered by these new rules, and sought guidance from the SEC staff accordingly.  The result was the issuance of two staff no-action letters that effectively blessed the practice of investment advisers rotely voting the recommendations of proxy advisors.[13]  I have spoken frequently and at length about the perceived safe harbor that these letters created and the fiduciary and other concerns they raise, and I have called for prompt Commission action to address the harm they have done.[14]

In a 2010 concept release often called the “proxy plumbing release,” the Commission revisited the question of proxy advisory firms by highlighting several issues, including conflicts of interest and the lack of accuracy and transparency in formulating voting recommendations.[15]  Attention to proxy advisory firms has, since then, increased both in the United States and abroad.[16]  

Last month’s Commission roundtable on the issue brought together a distinguished and diverse group of participants to discuss the role of proxy advisory firms and the services they provide.  Participants included representatives from proxy advisory firms, institutional shareholders, pension funds, investment advisors, legal practitioners and groups representing corporate secretaries and directors.  Among the topics discussed were the influence of proxy advisers on institutional investors, the lack of competition in this market, the lack of transparency in the proxy advisory firms’ vote recommendation process and, significantly, the obvious conflicts of interest when proxy advisory firms provide advisory services to issuers while making voting recommendations to investors.[17]

The feedback we have received confirms that the roundtable was an important first step towards proxy advisory reform.  While not everyone agrees on what the next steps should be, I see a common thread: there is a clear need for reform and sustained SEC attention.  The spirited, in depth discussions that took place at the roundtable and a burgeoning proxy advisory services comment file are evidence enough.[18]  In that vein, I want to take this opportunity to ask each of you to join in thinking about the influence of proxy advisory firms and I encourage you to provide your views to the Commission.  Start by asking yourselves whether the current role of proxy advisory firms and rote reliance on them by institutional investors advances the best interests of shareholders.  I think the answer is obvious, but the Commission can benefit from your views on which reforms would be most impactful.

* * *

In conclusion, I very much hope you will engage vigorously in the conversation regarding reforms to both our corporate disclosure system and the proxy advisory industry.  We need to hear directly from those of you who are daily and directly affected by the status quo.  As helpful as they have been, we don’t need any more concept releases or roundtables.  In both of these priority areas, we have a good idea of the problems and what needs to be done to fix them – and even where to begin, which is often the hardest part of enacting reforms.  There is no reason for further delay.  We have an opportunity to make good, incremental progress in this area.  We should not let a fixation on the perfect put at risk, or even delay getting started making such progress.

I appreciate the opportunity to share these thoughts with you this morning and look forward to your engagement – as well as your questions.

[1]   Louis D. Brandeis, Other People’s Money at 92 (1914).

[2]   Troy A. Paredes, “Blinded by the Light: Information Overload and Its Consequences for Securities Regulation,” 81 Wash. U. L. Q. 417 (2003). Available at:   http://digitalcommons.law.wustl.edu/lawreview/vol81/iss2/7 .

[3]   House Rep’t 113-172, Financial Services and General Government Appropriations Bill, 2014, at 71.

[4]   M. J. White, “The Path Forward on Disclosure,” speech to the National Association of Corporate Directors — Leadership Conference 2013 (Oct. 15, 2013). Available at: http://www.sec.gov/News/Speech/Detail/Speech/1370539878806.

[5]   JOBS Act, sec. 108(a).  The SEC Staff’s report was issued on December 20, 2013.  See, “Report on Review of Disclosure Requirements in Regulation S-K” (Dec. 2013) (“S-K Report”), available at http://www.sec.gov/news/studies/2013/reg-sk-disclosure-requirements-review.pdf.

[6]   S-K Report at 93.

[7]   Id. at 94.

[8]   Section 953(b).

[9]   Professor (and former SEC Commissioner) Joe Grundfest and former SEC Director of Corporation Finance Alan Beller made this point in their 2008 paper, “Reinventing the Securities Disclosure Regime: Online Questionnaires as Substitutes for Form-Based Filings,” Rock Center for Corporate Governance, Stanford University, Working Paper Series No. 2 (Aug. 4, 2008). Available at: http://ssrn.com/abstract=1235082.

[10]   The Commission adopted Form SD (17 CFR 249.448), in conjunction with adopting its rule to implement Section 1502 of the Dodd-Frank Act (“Conflict Minerals”) (Rel. No. 34-67716 (Aug. 22, 2012)). That same day, the Commission also adopted a rule to implement Section 1504 (“Disclosure of Payments by Resource Extraction Issuers”) of that Dodd-Frank Act, to which Form SD would also apply (Rel. No. 34-67717 (Aug. 22, 2012)). Both rules were subsequently challenged in court. The district court upheld the conflict minerals rule; its decision was appealed and argued in the D.C. Circuit on January 7, 2014.  The resource extraction rule was vacated and remanded to the Commission.

[11]   Final Rule: Proxy Voting by Investment Advisers, 68 FR 6585, available at http://www.sec.gov/rules/final/ia-2106.htm.

[12]   Id. Emphasis added.

[13]   See “Investment Advisers Act of 1940—Rule 206(4)-6: Institutional Shareholder Services, Inc.” SEC letter to Mari Anne Pisarri, September 15, 2004, http://www.sec.gov/divisions/investment/noaction/iss091504.htm and “Investment Advisers Act of 1940—Rule 206(4)-6: Egan-Jones Proxy Services,” SEC letter to Kent S. Hughes, May 27, 2004, http://www.sec.gov/divisions/investment/noaction/egan052704.htm.

[14]   See Commissioner Daniel M. Gallagher, “Remarks before the Corporate Directors Forum,” January 29, 2013 available at http://www.sec.gov/News/Speech/Detail/Speech/1365171492142#.UpENB3cgqSo; See Commissioner Daniel M. Gallagher, “Remarks at 12th European Corporate Governance & Company Law Conference,” May 17, 2013 available at http://www.sec.gov/News/Speech/Detail/Speech/1365171515712#.UpEMtXcgqSo; See Commissioner Daniel M. Gallagher, “Remarks at Society of Corporate Secretaries & Governance Professionals,” July 11, 2013 available at http://www.sec.gov/News/Speech/Detail/Speech/1370539700301#.UpEMPHcgqSo; See Commissioner Daniel M. Gallagher, “Remarks at Georgetown University’s Center for Financial Markets and Policy Event,” October 30, 2013 available at http://www.sec.gov/News/Speech/Detail/Speech/1370540197480#.UpEL9HcgqSo.

[15]   See Concept Release on the U.S. Proxy System, July 14, 2010, available at http://www.sec.gov/rules/concept/2010/34-62495.pdf.

[16]   See Commissioner Daniel M. Gallagher, “Remarks at Transatlantic Corporate Governance Dialogue Conference: The Realities of Stewardship for Institutional Owners, Activist Investors and Proxy Advisors,” December 3, 2013 available at http://www.sec.gov/News/Speech/Detail/Speech/1370540436067#.UtVfr3f3Jn8.

[17]   See SEC’s Proxy Advisory Services Roundtable Webpage available at
http://www.sec.gov/spotlight/proxy-advisory-services.shtml.

[18]   See Comments on Proxy Advisory Firm Roundtable available at http://www.sec.gov/comments/4-670/4-670.shtml.

CAPITAL REQUIREMENT PHILOSOPHIES BY SEC COMMISSIONER GALLAGHER

FROM:  SECURITIES AND EXCHANGE COMMISSION 
The Philosophies of Capital Requirements
 Commissioner Daniel M. Gallagher
Washington, DC
Jan. 15, 2014

Thank you, Sarah [Kelsey, Exchequer Club Secretary], for that introduction.  I’m very pleased to be here this afternoon.

Today, I’d like to talk about regulatory capital.  Given the usual reaction I get when I raise this subject, just to be safe, I’ve barred the exits!

In all seriousness, though, there’s been a great deal of attention paid to regulatory capital recently, including new Dodd-Frank requirements, Basel III implementation (or non-implementation) issues, and even bipartisan Congressional efforts to raise capital requirements for large banks.[1]  Almost all of that attention has naturally centered on the question of how much capital a financial institution should be required to hold.  What’s missing from the conversation, however – and what I’d like to focus on today – is a proper understanding of the theories behind capital requirements, both for banks and for non-bank financial institutions.

You may have noticed my reference to the theories behind capital requirements, rather than a single theory.  If so, you’re one step ahead of many policymakers both here and abroad, who often implicitly or explicitly advance a single, one-size-fits-all approach to capital.  As I’ll explain, this is a mistaken view that has the potential to impact the U.S. economy.

Understanding capital requirements begins with addressing the fundamental question of why financial institutions need minimum capital levels.  In the banking sector, where the regulated entities operate in a principal capacity and are leveraged institutions, capital requirements are rightly designed with the paramount goal of enhancing safety and soundness, both for individual banks and for the banking system as a whole.  Bank capital requirements serve as an important cushion against unexpected losses.  They incentivize banks to operate in a prudent manner by placing the bank owners’ equity at risk in the event of a failure.  They serve, in short, to reduce risk and protect against failure, and they reduce the potential that taxpayers would be required to backstop the bank in a time of stress.

Capital requirements for broker-dealers, however, serve a different purpose.  In the capital markets, we want investors and institutions to take risks – informed risks that they freely choose in pursuit of a return on their investments.  Eliminate the risk of an investment, and you eliminate the opportunity for a return as well.  Capital markets, in short, are predicated on risk.

Whereas bank capital requirements are based on the avoidance of failure, broker-dealer capital requirements are designed to manage failure by providing enough of a cushion to ensure that a failed broker-dealer can liquidate in an orderly manner, allowing for the orderly transfer of customer assets to another broker-dealer.

These two models of capital requirements, in other words, differ in fundamental ways - it’s certainly not a matter of comparing apples to apples.  Applying bank-based capital requirements to non-bank financial entities, in fact, is rather like trying to manage an orange grove using apple orchard techniques – it’s the equivalent of trying to determine how best to grow oranges to be used in orange pie, orangesauce, and, as a special treat, delicious caramel oranges on a stick.  If you think that metaphor is a bit strained, well, it is – but nowhere near as strained as imposing a bank capital regime on broker-dealers.

In order to fully understand the danger of imposing bank capital requirements on non-bank institutions, it’s helpful to take a bit of a detour to review the actions of the Federal Reserve during the height of the financial crisis, which leads us to that dreaded word: bailouts.

The word “bailout,” of course, has come to stand for everything wrong with the federal government’s response to the financial crisis.  As with, I imagine, everyone except for bailout recipients themselves, I find the idea of using taxpayer money to prop up insolvent financial institutions repugnant.  There’s a basic ant-and-grasshopper dynamic to bailouts: we naturally recoil from the idea of using the resources of prudent taxpayers to rescue institutions felled by their lack of prudence.  So let’s be absolutely clear: I hate bailouts.  We should all hate bailouts.  Case closed.

But…what, exactly, is a bailout?  Notwithstanding the risk of being misunderstood on an incredibly sensitive topic, I believe it is critically important to understand what is, and what is not, a bailout.  And here we come to the concept of the Federal Reserve as the lender of last resort and the crucial difference between insolvency and illiquidity for financial institutions.

The Federal Reserve Act of 1913 established the Fed, through its use of the discount window, as the nation’s lender of last resort.  The best starting point for understanding the concept of a lender of last resort remains Walter Bagehot’s seminal work Lombard Street.  Writing in 1873, Bagehot, who may be familiar to you from his work as editor-in-chief of The Economist or his treatise on the English constitution, set forth what is sometimes referred to as “Bagehot’s Dictum.”  My friend Paul Tucker, former Deputy Governor of the Bank of England, succinctly summarized Bagehot’s Dictum as follows: “to avert panic, central banks should lend early and freely…to solvent firms, against good collateral, and at ‘high rates.’”[2]

As you may recall me noting, I’m starkly against bailouts.  But offering access to the discount window to illiquid, but not insolvent, banks against good collateral comports with the traditional role of a central bank as the lender of last resort and falls outside even an expansive definition of the dreaded concept of a bailout.  Indeed, it falls squarely within the traditional understanding of a central bank’s paramount purpose.

In 2008, however, the Fed went well beyond offering access to the discount window to depository institutions in its capacity as the lender of last resort.  Instead, what happened in 2008 was that the Fed became the investor of last resort, a tremendously different concept which does indeed lend itself to the terrible title of “bailout.”  The acquisition of almost 80 percent of AIG in exchange for an $85 billion loan, for example, as well as the ownership of $29 billion in former Bear Stearns assets, marked a fundamental departure from the Fed’s traditional role.  As explained by Professor Allan Meltzer, author of a history of the Federal Reserve, “This is unique, and the Fed has never done something like this before.  If you go all the way back to 1921, when farms were failing and Congress was leaning on the Fed to bail them out, the Fed always said, ‘It's not our business.’ It never regarded itself as an all-purpose agency.” [3] One reporter aptly deemed the Fed’s actions in the financial crisis as a transformation into “The Fed Inc.”[4]

As the Fed explains on its web page detailing its “Mission,”[5] in an amusingly understated manner, “Over the years, its role in banking and the economy has expanded.”[6]  The Fed describes its current duties as conducting the nation's monetary policy, supervising and regulating banking institutions, maintaining the stability of the financial system and providing financial services to depository institutions, the U.S. government, and foreign official institutions.[7]  Notwithstanding the breadth of this mandate and the full plate of work you’d expect it to engender, the Fed has also taken steps to extend its regulatory paradigm – designed, once again, to prevent bank failures - to non-bank institutions as well.  Such institutions include broker-dealers, which, as I noted earlier, have their own regulatory capital regime that is designed to manage, rather than prevent, failure in order to ensure the return of customer assets. In addition, Title II of Dodd-Frank was explicitly designed not to prevent failure, but instead to manage the liquidation of large, complex financial institutions close to failure – indeed, the very name of the Title is “Orderly Liquidation Authority.”

In light of this, a more cynical person might suggest that the Fed’s efforts to extend the failure-prevention paradigm of bank capital regulation to financial entities that are already subject to failure-management regulatory schemes implies an institutionalization of the concept of too-big-to-fail.  Good thing I’m not a cynical guy.

I digress, but it is important to remember that the Fed’s lender of last resort activity during the financial crisis came after its intervention in the Bear failure as well as its bailout of AIG.  To be fair, once the Fed resumed its traditional role as the lender, rather than investor, of last resort, it did so robustly.  By March 2009, the Fed had lent a staggering $7.7 trillion dollars to beleaguered financial institutions, including $1.2 trillion on one day alone on December 5, 2008.[8]  And you thought your holiday spending was high!

So what does all of this have to do with capital?  To answer that question requires a better understanding of the recent and disturbing fascination with imposing bank-theory capital requirements on non-bank institutions.  Here, the recent FSOC intervention in the money market mutual fund space is quite instructive.

In August 2012, a lack of consensus among the Commission on the best way to proceed with proposing reforms to our money market fund rules led to an ill-advised abdication of the issue to FSOC, which enthusiastically took up the cause, leading to an unprecedented -- albeit invited -- incursion into the regulatory purview of an independent regulator.  The result was the issuance, in November 2012, of a report entitled “Proposed Recommendations Regarding Money Market Mutual Fund Reform,” in which FSOC floated – pun intended – the concept of a “NAV buffer,” that is, a capital requirement for money market funds.[9]

As I delved into the issue of money market fund reform following my return to the SEC as a Commissioner, it quickly became apparent to me that, perhaps in the hopes of staving off more stringent regulation, the industry was coalescing behind a capital buffer requirement of approximately 50 basis points, to be phased in over a several year period.  For the largest money market funds, this would have resulted in an approximately 1 to 200 ratio – a $500 million buffer to support $100 billion in investments.  This would amount to chicken feed in any serious capital adequacy determinations.

The ostensible reasoning behind a capital buffer for money market funds is that it would serve to mitigate the risk of investor panic leading to a run on a fund.  Common sense, however, belies this notion.  Do we really believe that investor panic would be assuaged by the comforting knowledge that for every one dollar they had on deposit, the money market fund had set aside half a penny?

Common sense also leads to the conclusion that there is no reason to assume that this view of capital requirements as a panacea to mitigate run risk is limited to money market funds.  Indeed, the now notorious “Asset Management and Financial Stability” report issued by Treasury’s Office of Financial Research last September featured similar reasoning, as reflected in its implied support for “liquidity buffers” for asset managers.[10]

As I noted in my statement at last June’s open meeting at which the Commission voted to propose reforms to our money market fund rules, which by the way thankfully did not include a capital buffer, “It became clear to me early on in this process that the only real purpose for the proposed buffer was to serve as the price of entry into an emergency lending facility that the Federal Reserve could construct during any future crisis – in short, the “buffer” would provide additional collateral to facilitate a Fed bailout for troubled MMFs.”[11]

Indeed, some Fed officials and academics[12] have suggested as much.  In a speech delivered last February, New York Fed President Bill Dudley, while expressing support for the FSOC-proposed money market fund reform mechanisms of a NAV buffer and a “minimum balance at risk,” explained his concern that “even after such reforms, we would still have a system in which a very significant share of financial intermediation activity vital to the economy takes place in markets and through institutions that have no direct access to an effective lender of last resort backstop.”[13]  He went on to raise the possibility of expanding access to the lender of last resort to additional entities in exchange for “the right quid pro quo—the commensurate expansion in the scope of prudential oversight.” Arguing that “[s]ubstantial prudential regulation of entities—such as broker-dealers —that might gain access to an expanded lender of last resort would be required to mitigate moral hazard problems,” he concluded, “Extension of discount window-type access to a set of nonbank institutions would therefore have to go hand-in-hand with prudential regulation of these institutions.”[14]

Fed Governor Daniel Tarullo, on the other hand, indicated his discomfort with extending access to the discount window to non-bank entities in a speech last November, noting that he was “wary of any such extension of the government safety net.”  In the context of addressing the “vulnerabilities” of short-term wholesale funding, he stated that he “would prefer a regulatory approach that requires market actors using or extending short-term wholesale funding to internalize the social costs of those forms of funding”[15] – that is, an increased capital charge. In a different speech earlier last year, he cited the risk of “regulatory arbitrage” if increased capital charges were applied “only to some types of wholesale funding, or only to that used by prudentially regulated entities”[16] and concluded, “Ideally, the regulatory charge should apply whether the borrower is a commercial bank, broker-dealer, agency Real Estate Investment Trust (REIT), or hedge fund.”[17]

All of this adds up to a terribly muddled situation.  Is the Fed seeking to impose bank-based capital charges on non-bank entities in conjunction with granting them access to the discount window at the cost of submitting to prudential regulation, as Mr. Dudley suggests?  Or is the situation just the opposite, as Governor Tarullo implies – would those additional capital charges be intended to prevent non-prudentially regulated financial entities from ever relying upon, as Governor Tarullo puts it, an extension of the “government safety net” the discount window provides?

Put another way, is the goal to expand the Fed’s role by making it the lender of last resort to non-bank entities such as money market funds and broker dealers, or is it to use its Bank Holding Company Act authority and its role in FSOC to dictate capital requirements to non-bank entities in order to prevent those entities from ever gaining access to the discount window?

These are more than purely semantic questions, although semantics play a role: one man’s expansion of the Fed’s role as the lender of last resort is another man’s institutionalization of bailouts for failing financial institutions.

In my opinion, both Governor Tarullo and Mr. Dudley raise very good points that warrant a healthy debate.  The issues they raise, however, as well as the more general issue of how much capital is enough in the banking and capital markets, create a degree of confusion about the Fed’s role as the lender of last resort.  Should the Fed still perform that role?  If so, when and for what entities?  Does such lending, in fact, constitute a bailout?

All of these questions require answers as we debate questions of capital adequacy.  If we are to assume that the Fed will not, or cannot, expand its role as the lender of last resort to non-bank entities, including non-bank subsidiaries of bank holding companies, would it ever be possible to set capital requirements at a level that would guarantee avoidance of 2008-type scenarios?  I think not, even if we were to impose capital requirements of 100%.  To me, therefore, capital markets regulators simply cannot stray from the theory of capital as a tool to facilitate the unwinding of a failed firm with the goal of returning customer assets.

I certainly don’t want to leave the impression that I disregard the Fed’s concerns about capital requirements for bank affiliated non-bank financial institutions.  Indeed, it is my hope in the coming year to work with Commission staff and FINRA to begin an in-depth review of whether it would be appropriate to establish separate capital rules for bank-affiliated broker-dealers.  If we determine that such a bifurcated broker-dealer capital regime would be appropriate, however, any such regime would be based on the principles of our current program for broker-dealer net capital, and it would be crafted to stand on its own, without any reference to the discount window.  On this and related issues, it is far past time that the SEC play an active role in the policy debate in order to ensure the ongoing vibrancy of our capital markets.

Before I conclude, I’d like to make one final point that is obvious but still needs to be reiterated: the judgment calls regulators make in establishing capital rules incentivize regulated entities in a manner that inevitably results in unforeseen (although often quite foreseeable) externalities.  A classic example is the beneficial capital treatment provided to certain asset-back securities under what’s known as the “Recourse Rule.”[18]  The Recourse Rule, issued by the Fed, the FDIC, the OCC and OTS as a supplement to their implementation of Basel I, hugely privileged highly rated ABS as well as ABS issued or guaranteed by a GSE.  How hugely? Well, for every $100 of highly rated or GSE sponsored ABS, well-capitalized banks had to set aside $2.  This compared to a $5 set-aside for unsecuritized mortgage loans and a $10 charge for commercial loans or corporate bonds.  In other words, by holding ABS from these favored categories, banks could reduce their capital requirements by 60% compared to holding an equivalent amount of mortgage loans and by 80% compared to holding corporate loans or bonds.

I’m reminded of the ubiquitous TV commercials featuring children’s responses to simple questions: what’s better, bigger or smaller, faster or slower, more or less?  As the ads say, it’s not complicated.  Concluding that setting aside less capital was better than setting aside more capital, banks loaded up their balance sheets accordingly, and by 2008, a staggering 93 percent of all the mortgage-backed securities held by American banks were either GSE-issued or rated AAA.[19]  As noted in a 2010 report issued by the American Enterprise Institute, “If not for the recourse rule's privileging of mortgage-backed bonds, the burst housing bubble almost certainly would not have caused a banking crisis. The banking crisis, in turn, froze lending and caused the Great Recession.”[20]

As the Recourse Rule illustrates, regulatory capital requirements play a tremendous role in incentivizing financial institutions’ holdings.  All the more important, therefore, that regulators use the right tool for the right job.  We rightly take great pride in our capital markets, the deepest and safest in the world.  We’re an entrepreneurial nation, and taking risks, whether with respect to investments or otherwise, is as American as apple pie.  Superimposing upon those markets a capital regime based on the safety-and-soundness banking paradigm, on the other hand, would be as sensible as orange pie.

Thank you all for your attention this afternoon.  I’d be happy to take questions.


[1] Terminating Bailouts for Taxpayer Fairness Act of 2013, S. 798, 113th Cong. (2013).

[2] Paul Tucker, Deputy Governor, Financial Stability, Bank of England, The Repertoire of Official Sector Interventions in the Financial System: Last Resort Lending, Market-Making, and Capital (May 28, 2009), available at http://www.bankofengland.co.uk/archive/Documents/historicpubs/speeches/2009/speech390.pdf.

[3] Edmund L. Andrews, A New Role for the Fed: Investor of Last Resort, N.Y. Times, September 18, 2008, available at http://www.nytimes.com/2008/09/18/business/18fed.html?pagewanted=print.

[4] Id.

[5] http://www.federalreserve.gov/aboutthefed/mission.htm

[6] Id.

[7] Id.

[8] Bob Ivry, Bradley Keoun and Phil Kuntz, Secret Fed Loans Gave Banks $13 Billion Undisclosed to Congress, Bloomberg, November 27, 2011, available at

http://www.bloomberg.com/news/2011-11-28/secret-fed-loans-undisclosed-to-congress-gave-banks-13-billion-in-income.html. By comparison, Treasury’s much better-known TARP program entailed a mere $700 billion.

[9] Financial Stability Oversight Council, “Proposed Recommendations Regarding Money Market Mutual Fund Reform” (November 2012), available at http://www.treasury.gov/initiatives/fsoc/Documents/Proposed%20Recommendations%20Regarding%20Money%20Market%20Mutual%20Fund%20Reform%20-%20November%2013,%202012.pdf.

[10] U.S. Department of Treasury, Office of Financial Research, “Asset Management and Financial Stability,” (September 2013), available at http://www.treasury.gov/initiatives/ofr/research/Documents/OFR_AMFS_FINAL.pdf.

[11] Daniel M. Gallagher, Commissioner, Sec. & Exch. Comm’n, Statement at SEC Open Meeting – Proposed Rules Regarding Money Market Funds (June 5, 2013), available at

 http://www.sec.gov/News/Speech/Detail/Speech/1365171575594#.UsneCvRDvqN.

[12] See, e.g., Comment Letter of Jeffrey N. Gordon (File No. FSOC-2012-0003) (Feb. 28, 2013), available at http://www.regulations.gov/#!documentDetail;D=FSOC-2012-0003-0131).

[13] William C. Dudley, President and Chief Executive Officer, Federal Reserve Bank of New York, Fixing Wholesale Funding to Build a More Stable Financial System (February 1, 2013), available at      http://www.newyorkfed.org/newsevents/speeches/2013/dud130201.html.

[14] Id.

[15] Daniel K. Tarullo, Governor, Board of Governors of the Federal Reserve System, Shadow Banking and Systemic Risk Redgulation (November 22, 2013), available at http://www.federalreserve.gov/newsevents/speech/tarullo20131122a.htm.

[16] Daniel K. Tarullo, Governor, Board of Governors of the Federal Reserve System, Evaluating Progress in Regulatory Reforms to Promote Financial Stability (May 3, 2013), available at http://www.federalreserve.gov/newsevents/speech/tarullo20130503a.htm.

[17] Id.

[18] Risk-Based Capital Guidelines; Capital Adequacy Guidelines; Capital Maintenance: Capital Treatment of Recourse, Direct Credit Substitutes and Residual Interests in Asset Securitizations, 66 Fed. Reg. 59613 (November 29, 2001).

[19] Jeffrey Friedman and Wladimir Kraus, “A Silver Lining to the Financial Crisis,” American Enterprise Institute for Public Policy Research Regulation Outlook at 3 (January 2010), available at http://www.aei.org/files/2010/01/19/01-2010-Regulation-g.pdf (citing Viral V. Acharya and Matthew Richardson, “Causes of the Financial Crisis,” Critical Review 21 no. 2–3 at 195–210, table 1 (2009), available at http://pages.stern.nyu.edu/~sternfin/vacharya/public_html/acharya_richardson_critical.pdf)). See also Jeffrey Friedman, “A Perfect Storm of Ignorance,” Cato Policy Report (January/February 2010), available at http://www.cato.org/policy-report/januaryfebruary-2010/perfect-storm-ignorance.  Note that this figure would be even higher if it included Recourse Rule-friendly AA-rated securitizations.

[20] Friedman and Kraus at 4.

SEC VOTES ON EXECUTIVE "PAY RATIO" PROPOSAL AND DISSENTING OPINION

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 
Sept. 18, 2013

The Securities and Exchange Commission today voted 3-2 to propose a new rule that would require public companies to disclose the ratio of the compensation of its chief executive officer (CEO) to the median compensation of its employees.

The new rule, required under the Dodd-Frank Act, would not prescribe a specific methodology for companies to use in calculating a “pay ratio.”  Instead, companies would have the flexibility to determine the median annual total compensation of its employees in a way that best suits its particular circumstances.

“This proposal would provide companies significant flexibility in complying with the disclosure requirement while still fulfilling the statutory mandate,” said SEC Chair Mary Jo White.  “We are very interested in receiving comments on the proposed approach and the flexibility it affords.”

The proposal will have a 60-day public comment period following its publication in the Federal Register.


Dissenting Statement of Commissioner Daniel M. Gallagher Concerning the Proposal of Rules to Implement the Section 953(b) Pay Ratio Disclosure Provision of the Dodd-Frank Act

Commissioner Daniel M. Gallagher
SEC Open Meeting, Washington, D.C.
Sept. 18, 2013

Today, the Commission will vote on proposed rules to implement yet another Dodd-Frank mandate having nothing to do with the SEC’s mission and everything to do with the politics of not letting a serious crisis go to waste.

The pay ratio computation that the proposed rules would require is sure to cost a lot and teach very little.  Its only conceivable purpose is to name and, presumably in the view of its proponents, shame U.S. issuers and their executives.  This political wish-list mandate represents another page of the Dodd-Frank playbook for special interest groups who seem intent on turning the notion of materiality-based disclosure on its head.

There are no – count them, zero – benefits that our staff have been able to discern.  As the proposal explains, “[T]he lack of a specific market failure identified as motivating the enactment of this provision poses significant challenges in quantifying potential economic benefits, if any, from the pay ratio disclosure[.]”[1]

So much for the benefits.  If you don’t have a good imagination – or a robust political agenda – you simply won’t find any.

*  *  *

It could have been worse, and I commend, as always, our expert staff in the Division of Corporation Finance, under the Chair’s direction, for taking a somewhat more flexible approach to the proposal than many which have been considered.  But the fact that the Commission could have imposed even greater costs does not create some otherwise absent benefit to mitigate the wasteful costs of the proposal.  It merely confirms that there are even more costly ways to accomplish nothing.

So why do this at all?  Simple.  Dodd-Frank says we must.[2]  Crossing one more required rule proposal off our long to-do list of unfinished Dodd-Frank mandates might be the closest thing to a benefit that an objective analysis can squeeze out of today’s proposal.

It's important not to forget, however, that the pay ratio mandate, unlike so many in Dodd-Frank, carries no congressionally imposed deadline.  We need not act on it now or soon.  It has, nevertheless, jumped to the front of the queue.

We must, therefore, acknowledge as another cost of the rule the decision not to do something else, something more pressing, something that would have yielded discernible benefits – a JOBS Act rulemaking to address the ongoing employment crisis in this country, perhaps, or something – anything – to do with the financial crisis – maybe, for example, the Dodd-Frank section 939A rulemaking that is years overdue.

Given the tremendous strain placed on our resources by Dodd-Frank's seemingly endless stream of mandates as well as our "day job" of doing the blocking-and-tackling work that actually protects investors, maintains fair, orderly, and efficient markets, and facilitates capital formation, today's rulemaking represents a significant and distressing misallocation of time and resources.

*  *  *

Section 953(b) of Dodd-Frank mandates the application of the pay ratio requirement to “each issuer.”  A flexible approach, designed to reduce costs to issuers, would have defined the word “issuer” simply to mean the registrant itself, thus requiring issuers to include only their own employees in the median employee compensation calculation.  Such an interpretation would also have the benefit of being consistent with the plain language of the statute.  It would have been consistent with the definition of the term “issuer” in both the Securities Act and the Exchange Act, which define the term to mean any person who issues or proposes to issue any security.[3]

This morning’s proposal, however, interprets the term “issuer” by reference to Item 402 of Regulation S-K, which has enterprise-wide applicability and so concludes that in section 953(b) the term “issuer” should likewise have enterprise-wide scope.[4]  This inflexible interpretation has the effect of bringing exponentially more entities – and all of their employees’ compensation – into the pay ratio provision’s costly ambit.

Even more problematically, the proposal would extend the scope of the proposed rules further by requiring the calculation of the median salary and, therefore, the resulting ratio, to be global – that is, applicable not only to the full-time U.S. employees of the issuer and its subsidiaries, but to all of its employees everywhere in the world – including the worldwide employees of its subsidiaries.  And the median calculation must include seasonal, temporary, and part-time employees – assuming they are on the rolls at fiscal year’s end – without, however, requiring annualization of their compensation.[5]

Even from the perspective of the 953(b) supporters, these interpretations of the statute are unnecessary overkill.  Requiring issuers to calculate the median salary based solely on their own full-time employees located in the United States would still have yielded pay ratio figures more than impressive enough to serve the law’s scapegoating and shaming goals. Such a calculation would still have been complex, although much less costly and more in line with our responsibility as regulators to strike an appropriate balance between costs and benefits.

In addition, a more reasonable, literal interpretation of the statutory mandate would have avoided the distortions the chosen method inevitably introduces.  Why, after all, should we require a global calculation, thereby introducing a non-scientific and uninstructive comparison that ignores the variances in the costs of labor and the costs of living in widely disparate economies worldwide?[6]  Of what conceivable use could comparing the pay of workers in developing nations to that of U.S. CEOs be to the investors the SEC is tasked with protecting?  Why include part-time and temporary and seasonal employees?  Why incorporate currency exchange assumptions or pay variations due to governmental social benefits schemes that vary from country to country?  These and other extraneous variables introduce a degree of complexity and obfuscation that renders meaningless what was meant to be a simple ratio.

The only logical conclusion is that the real point of this exercise is to ensure the most eye-poppingly huge ratios possible.  Gimmicks like these don’t belong in corporate filings.  The agency would sanction issuers who acted so “creatively” in other areas of their 10K or proxy disclosure.

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Finally, I remind the Commission, once again, that the Exchange Act mandates that we consider the effect of what we do on competition,[7] which even the proposal itself acknowledges by noting, “the competitive impact of compliance with the disclosure requirements prescribed by Section 953(b) could disproportionately fall on U.S. companies with large workforces and global operations….”[8]  Notwithstanding this clear mandate, today’s proposal continues a trend of politically motivated new disclosure requirements that impose unnecessary compliance costs on U.S. issuers, reducing their international competitiveness while providing no benefits to investors and political benefits to special interest groups.[9]

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Putting the most positive face possible on today’s proposal, then, its benefits are not so much elusive, as illusory.  Indeed, the “benefits” portion of our economists’ evaluation of the proposed rules is really just a discussion of relative costs.  It amounts to this:  Congress told us to do it, and since we could have done it in a more costly way than we did, the result is an implicit net benefit.  I believe this is the best that DERA could do with such a rotten mandate, but none of us should be happy about it.

I cannot see any way to support today’s proposal.  I lament the time wasted on it, and I urge investors, public companies and others directly affected by the proposal to submit detailed, data-heavy comments.


[1]   Release at p. 91 (“Economic Analysis”).

[2]   Note, however, that on June 19, 2013, a bipartisan majority of the House Financial Services Committee reported favorably H.R. 1135, which would repeal Section 953(b).

[3]   Securities Act, sec. 2(a)(4); Exchange Act, sec. 3(a)(8).

[4]   “By directing the Commission to amend Item 402, we believe that Section 953(b) is intended to cover employees on an enterprise-wide basis, including both the registrant and its subsidiaries, which is the same approach as that taken for other Item 402 information” (Release at p. 110), and “we believe it is appropriate to apply the same definition of subsidiary that is used for other disclosure under Item 402” (id. at 111).

[5]   The Release permits annualization for permanent employees, which would include those employed at fiscal year’s end but not for the whole fiscal year, as well as permanent part-time employees.  It does not permit annualization for seasonal or temporary employees employed at year’s end.  Release at 33-34 and 114-15.

[6]   The Release acknowledges that any comparison of registrants’ pay ratios would be uninstructive:  “[W]e do not believe that precise comparability or conformity of disclosure from registrant to registrant is necessarily achievable due to the variety of factors that could cause the ratio to differ…” (Release at 35).

[7]   Exchange Act, sec. 23(a)(2).

[8]   Release at p. 104 (“Economic Analysis”).

[9]   See, e.g., Release No. 34-67716 (“Conflict Minerals”), Aug. 22, 2012, and Rel. No. 34-67717 (“Disclosure of Payments by Resource Extraction Issuers”), Aug. 22, 2012 (subsequently vacated and remanded).