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Weekly UpdatesFOR THE PAST TWO YEARS we have issued a report card that evaluated the Securities and Exchange Commission's record for the previous year. Our negative marks and remarks may have raised some eyebrows, but the past year's events have garnered national recognition for the significant failures of the SEC. In light of current events, it is pointless to grade the SEC's performance--the agency has clearly tailed to fulfill the purpose for which it was created: to protect investors and maintain fair and orderly securities markets.
Congress created the SEC because it believed, following the frenzy of 1929 and the chaos that followed, that it is in the national public interest to regulate transactions in securities--such transactions being all too often susceptible to manipulation and control, excessive speculation, and sudden and unreasonable price fluctuations. It is profoundly ironic that, three-quarters of a century after its creation, the SEC is facing a foundational crisis similar to the one that led to its creation in the first place.
Unfortunately, since its creation, the SEC has seemed to be chasing the ball with respect to regulating the market. It missed Enron. It missed Madoff. And, most catastrophically, it missed the looming credit and financial crisis. To be effective, the SEC must not only address the concrete issues that the current financial crisis has exposed, but must also reexamine its objectives and return to the limited--but critical--original mission. Here are the four steps the SEC should take immediately in order to function more effectively and restore public confidence.
1. Back to basics: Restore the original mission
The Securities and Exchange Commission, historically, defined itself by representing the interests of those who are otherwise not represented by Wall Street law firms and securities market professionals--namely, small investors. At its origin, the Commission sat at the intersection of Wall Street and Main Street. It was not tasked nor did it seek to promote capital formation, fiscal policy, or monetary policy. Rather, it focused entirely on preventing inequitable and unfair practices in securities markets; whether it was proceeding by regulation or litigation, the SEC, at core, is a law enforcement agency. This is a mission that the Commission must regain.
Of course, times have changed and the SEC must be redefined to accommodate the market dynamics of the 21st century. In the past, government has regulated entities by what they are (stockbrokers, commercial bankers, insurance agents, investment bankers, commodity futures commission merchants, etc.) rather than what they do (create and distribute investment products, syndicate commercial loans, project price discovery, etc.). We now know that there is a hard-wired linkage between what market professionals of every stripe do, irrespective of what they are. Failure to regulate from that perspective can be catastrophic.
This means that the Commission as well as other executive and regulatory agencies in Washington will have to be dramatically recast to be effective in this new environment. Redefining the regulatory role of the agency is a task for Congress, but the Commission can work within its current regulatory framework to demand greater transparency from market professionals so as to better understand the risk inherent in certain transactions and determine appropriate action.
Much of the current crisis is largely the result of the regulatory community not understanding the risk characteristics of the investment and loan portfolios of so many collective investment entities (that is, banks, brokers, hedge funds, private equity funds, insurance companies, etc.). No one knew how much leverage existed on the books of hedge funds and off-balance-sheet special purpose vehicles--so-called SPVs. In order to be effective, the SEC must fully understand the SPVs, correctly identify when those SPVs are actually investment vehicles, proactively identify those investment vehicles that carry the greatest risk, and act appropriately to regulate in the interest of the small investor.
2. Investigate fraud in the credit default swaps market
Although the SEC must move forward, it cannot let the mess that led to the financial crisis go unanswered. A preliminary step is for the SEC to identify credit default swaps (CDS) for what they are--investment contracts--and begin an immediate investigation into fraud abuses that have occurred in that market. The SEC must take on the CDS market in order to prove that it is capable of keeping pace with the continually innovating market professionals who find new ways of making money--sometimes (as with CDS) where no new product or services are provided.
Without the ability to identify and regulate nontraditional investment vehicles, the SEC will continuously be chasing Wall Street, stepping in to regulate only after a financial disaster has proved the broader interconnections between financial innovations and national financial stability. Nor can the SEC limit itself to the CDS market. It must proactively identify new investment vehicles as they emerge--regardless of what they are called--and move forward with appropriate regulation.
3. Federal chartering of public companies
Since the Enron debacle, there has been push for standardizing certain disclosures on the part of public companies. There has also been a push for greater transparency on executive compensation, including disclosure of non-monetary perks--such as company cars and private jets--that allow executives to enjoy luxuries at the shareholder's expense. The current financial crisis has renewed calls for limitations on executive compensation.
The SEC should push the ball even further and move toward federal chartering of public companies. This could be the vehicle through which the SEC is able to set up uniform standards for corporate governance, investor access to corporate proxy statements, annual disclosures and, finally, to rein in executive compensation.
4. Forfeiture of bonuses and stock sale proceeds
Finally, and perhaps most controversially, the Commission should move forward with the authority conferred upon it by Sarbanes-Oxley Section 304 to seek forfeitures of bonuses and stock sale proceeds from every executive of every principal financial, industrial, and service business that has restated its prior period financials to reflect the reality which the credit crisis has now exposed.
Transparent markets will be fair and orderly and the government's responsible officials (whether they are called SEC staffers or otherwise) can return to the task of assuring that manipulation and abuse will not hinder owners, buyers, and sellers of securities or prevent the fair valuation of their in vestments. We have enjoyed nearly 100 years of depth and liquidity in our capital markets coupled with price continuity that has only recently been fouled. Investors will come back to this market when depth, liquidity, and continuity return. This is the daunting task facing the SEC--and one that will be significantly underway if the four steps noted above are implemented.
The authors can be contacted at rferrara@deweyleboeuf.com and riva.parker@gmail.com.
Ralph C. Ferrara (pictured) is managing partner of the Washington, D.C., office of Dewey & LeBoeuf LLP (www.deweyleboeuf.com). He is a former general counsel of the Securities and Exchange Commission. Riva Khoshaba Parker was an associate in the Washington office of Dewey & LeBoeuf for four years.
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