SEC bound to protect less sophisticated investors

The following is an edited version of a speech given Sept. 12 by Elisse B. Walter, a member of the Securities and Exchange Commission, in Wichita, Kan., at the annual conference of the North American Securities Administrators Association Inc.

Markets are the aggregation of millions of decisions by people and institutions who are, quite naturally, probably more interested in their own investments than in economic theory.

This reality places many investors — particularly retail investors — at a sometimes significant disadvantage. And it means that at a time when investments by American families are increasingly important to achieving what many of us still call the American dream, it is vitally important that we continue our efforts to level the playing field that many fear has become increasingly tilted against retail investors.

There is a strong argument to be made that today’s investors, including many retail investors, are more sophisticated than [ever]. After all, investors with cable TV can choose among business-only networks and find the advice of Jim Cramer or get Maria Bartiromo’s latest take from the floor of the New York Stock Exchange. And investors can access dozens of publications and hundreds of blogs offering everything from detailed financial analysis to rumors and tips.

Despite the vast amount of information available, however, there is a growing gap between the sophistication of the financial markets and the sophistication of most retail investors — who often are incapable of processing that information. In addition, there are studies showing that some relatively sophisticated individual investors actually are even more likely than others to follow fraudulent advice.

The growing complexity of the financial world leaves investors of levels of sophistication more open not only to Ponzi schemers and fraudsters but also to investment professionals with conflicting interests and even to their own overestimated level of sophistication. These vulnerabilities can plunge an unprepared investor into the complex worlds of leveraged exchange-traded funds or foreign-exchange speculation, with sometimes devastating consequences. Not only that, but even savvy investors with an accurate grasp of their own abilities and the market’s risks must carefully navigate a financial system where individual transactions are executed, orders are placed and canceled, and markets move — all rapidly — or risk devastating consequences themselves.

At the same time that investor vulnerabilities appear to be increasing, the results of any misstep are becoming increasingly harsh. Never has the ability to achieve and to hold on to the American dream been more dependent on successful investing by middle-class Americans. We live in a world where so many major life decisions — from getting an education to buying a home to preparing for a child’s future or, especially, for retirement — depend on an individual’s investment success.

Workers looking towards a comfortable retirement often now have to punch the clock at jobs where the defined-benefit pension plan, which used to pay retirees a specific retirement benefit, is simply a memory.

FAMILIES MUST RELY ON INVESTMENTS

Social Security and Medicare both face pressures. And the value of the family home — traditionally a middle-class family’s largest investment — has declined dramatically over the past few years. Rather than a diverse mix of incomes and assets, Americans increasingly are being forced to rely on their own investments for retirement security. In addition, the cost of college, still a key to security for many, has been rising at twice the rate of inflation — and of middle-class wages — for 20 years.

Against this backdrop, a worker who makes a big bet on a complicated fund, or who gets swept up in the sophisticated-sounding patter of a friend-of-a-friend who’s allegedly earning clients 4% a month by flipping foreclosed properties — can turn his or her comfortable retirement into a meager one or wipe out his children’s college savings.

The SEC’s enforcement division and your agencies view activities that run afoul of our securities laws from different vantage points, meaning more-effective scrutiny of suspicious participants and trends. Each agency has its own advantages — sometimes procedural, sometimes in the experience and expertise of its staff — that can come together to make stronger cases. We benefit from the tips and complaints that we pass each other’s way. The coordination of state and federal action maximizes the reach of our resources and can allow each of us to do more for investors within all-too-tight budgets.

This summer, we saw a tremendous example of a coordinated state-federal action against Morgan Keegan [& Co. Inc.], which had mispriced risky mortgage-backed securities that it had bundled into supposedly conservative mutual funds. In June, the [SEC, Finra] and a task force of state regulators from Alabama, Kentucky, Mississippi, South Carolina and Tennessee announced a $200 million settlement against Morgan Keegan. One senior executive was barred from the securities industry, $100 million was placed in a federal Fair Fund for harmed investors and $100 million was paid into a state fund that also is being distributed to investors. The case was a tremendous example of what we can accomplish for investors when we work together. And it sent a strong message that unscrupulous actors should fear both state and federal scrutiny, and prosecution, if they violate securities laws.

In addition to our collaboration on the enforcement front, the Dodd-Frank Act presents more opportunities for state and federal regulators to work together to enhance investor protection.

So let me give you a quick look at some of the progress we have made against a pressing rule-making docket over the last 13 months.

Of the more than 90 mandatory rule-making provisions, the SEC already has proposed or adopted rules for almost three-quarters of them — not including rules stemming from the dozens of other provisions that give the SEC discretionary rule-making authority. Additionally, the SEC has issued eight of the more than 20 studies and reports that it is required to complete under the act.

We are proceeding rapidly but deliberately. Meeting deadlines for writing rules is important to us. But our first priority is to propose and adopt rules that work.

TWO PARTS OR ONE?

There’s a temptation to think about Dodd-Frank financial system reforms as comprising two discrete, though related, pieces, with one portion of the law largely addressing systemic stability and the other focused on what we would think of as investor protection. I don’t think the division is quite so neat, however. Both are important to the retail investor.

One key area of SEC focus is the asset-backed-securities market — the market for securities with value and revenue streams based on assets like bundled car loans or credit card payments.

As you know, the financial crisis saw the collapse of one particular class of securitized assets — those based on subprime mortgages.

During the housing bubble, banks and mortgage companies found that they could write mortgages and then sell them off — pocketing the origination fee and passing the risk down the securitization chain. Securitizers then bundled the loans and sold them, washing their hands of risk related to the loans’ performance.

Since originators and securitizers bore no risk, they had no incentive to maintain high underwriting standards. In his book ”The Big Short” (Norton, 2010), Michael Lewis tells of a strawberry picker with $14,000 in annual income and a tenuous grasp of the English language who was cleared for a mortgage on his very own $750,000 minimansion. In the era of “interest-only,” “option [adjustable-rate mortgages]” and “liar loans,” mortgage originators routinely pushed loans out the door with little or no consideration of whether mortgagees would be able to pay.

Title IX of the Dodd-Frank Act puts an end to liar loans by requiring that securitizers retain at least 5% of the credit risk of any assets they sell. It also prohibits a securitizer from directly or indirectly hedging or otherwise transferring that credit risk.

REDUCING THE HAZARD

In March, the commission joined federal banking and housing agencies in proposing rules to meet these standards, offering a menu of risk retention options. We believe that reducing the moral hazard that made liar loans common will impose needed discipline on the mortgage marketplace.

The negligence and outright fraud that too often marked bubble-era mortgage underwriting was compounded by problems with credit ratings. For example, as late as January 2008, 64,000 asset-backed securities were rated triple A. Unfortunately, 90% of them were later downgraded to junk status.

In January, the commission adopted the first of approximately a dozen required rule makings related to credit ratings agencies. In May, it published for public comment a series of proposed rules that would strengthen the integrity of credit ratings, including by improving their transparency. And we are removing references relying on ratings from many of our rules.

The one area where federal and state regulatory interests most overlap involves financial advisers.

As you know, Dodd-Frank recognizes the systemic importance of hedge funds and other private funds by placing their advisers under SEC oversight and requiring that the SEC gather certain information about private funds for the Financial Stability Oversight Council. Even as we are acquiring oversight of hedge fund advisers, under Dodd-Frank, the responsibility for regulating approximately 3,200 investment advisers with assets under management of between $25 [million] and $100 million will now move to the states.

We have been working closely with NASAA and its members since passage of Dodd-Frank, both to ensure a smooth transition between the SEC and the states and also to ensure that investment advisers have clear guidance on new registration procedures.

One significant bar to effective oversight over investment advisers by the SEC that remains, and will only grow in the future, is the inability to examine with sufficient frequency the 9,750 advisers that will be registered with the agency. Effective oversight depends on adequate resources, and we share the need to obtain them, given ever-more-difficult budgetary problems.

Americans currently entrust $43 trillion to the management of SEC- registered investment advisers. Yet as things stand, the average investment adviser can expect to be examined by the SEC only once every 11 years. These decreases appear to be attributable, in part, to the consistent growth in the investment advisory industry — in terms of both an increase in number of investment advisers and an even greater increase in assets under management. The inevitable conclusion to be drawn from these decreases is that the commission is not [fulfilling], and unless significant changes are made, [the SEC] cannot fulfill its examination mandate with respect to investment advisers.

The SEC’s Office of Compliance Inspections and Examinations will have fewer investment advisers to examine in the years immediately following the reallocation of responsibilities for the regulation of smaller investment advisers to the states. But any relief would likely be only temporary, as the number of firms and the amount of assets under management will continue to grow, and the advisers under our oversight will be, on average, larger and more complex. In addition, other new areas required to be regulated under Dodd-Frank will compete for resources from the advisory area. These areas include municipal advisers, credit ratings agencies, security-based-swap dealers, and security-based-swap repositories. And a new whistle-blower program is likely to stretch limited resources even further, as examiners may be diverted from regular exams to follow up on tips.

ENHANCING ENFORCEMENT

It has been evident for some time that something needs to be done. Section 914 of Dodd-Frank requires the commission to review and analyze the need for enhanced examination and enforcement resources for investment advisers. The commission voted this year to release the 914 study, which discussed three options to address the significant need for improvements in this area:

• Impose user fees on investment advisers and expand [the Office of Compliance Inspections and Examinations].

• Authorize one or more self-regulatory organizations similar to [the Financial Industry Regulatory Authority Inc.], which oversees broker-dealers, to oversee registered investment advisers.

• Authorize Finra to examine dually registered investment advisers and broker-dealers for compliance with the [Investment] Advisers Act [of 1940].

I was quite disappointed with the result of the study. Although it was an extremely difficult decision, I ultimately felt that it was necessary for me to submit a separate statement to provide straightforward responses to congressional inquiries, clarify and emphasize certain facts and ensure Congress was fully aware of the severity of the commission’s resource problem — that it would only worsen and that a solution is needed now.

Although I felt that each of the options discussed holds some promise, the study’s description and weighing of them was far from balanced or objective, and generally it was predisposed against an SRO option. I undertook to balance the discussion.

The discussion on this important topic continues. I also would note that unfortunately, opposition to user fees and the difficulties of an annual appropriations process make it difficult to foresee a situation in which this Congress would allocate the resources the SEC would need to significantly increase the size of its examination team.

I am pleased, though, that Congress is again focusing on improving investment adviser oversight, with Chairman [Spencer] Bachus [R-Ala.] of the House Financial Services Committee offering for discussion legislation authorizing SROs for investment advisers to supplement the commission’s oversight. I believe that swift and decisive action is critical — not relegation to another day.

We share an interest in seeing that investment professionals provide advice with their clients’ best interests in mind. A report mandated by Dodd-Frank and released to Congress last January, in which I wholeheartedly joined, recommended that investment advisers and broker-dealers both be held to a uniform federal fiduciary standard when they are providing personalized investment advice.

Adoption of a uniform fiduciary standard has long been a goal of mine, and I look forward to moving forward on this initiative. However, in addition to establishing a uniform fiduciary standard, I would also like to see us work toward harmonizing aspects of the regulation of broker-dealers and investment advisers. As I have said before, when investment advisers and broker-dealers are performing the same or substantially similar functions, they should be subject to the same or similar regulations. Regardless of changes in the relationship between investors and the professionals to whom they turn for advice, disagreements will arise that need to be resolved quickly and fairly. Following the dictates of Dodd-Frank, the SEC intends to thoroughly review the mandatory-arbitration provisions that are written into most brokerage contracts.

I believe that in recent years, Finra has provided a relatively cost-effective way to fairly resolve disputes. Nonetheless, I also completely understand the frustration of investors who are denied their opportunity for a day in court and find themselves forced to make their case in front of an arbitration forum.

Of course, investor protection efforts need to evolve as markets evolve over time, so an important facet of Dodd-Frank is that it ensures that state regulators are in the room when key decisions about financial regulations are considered.

Dodd-Frank also ensures a voice for state securities regulators on the Investor Advisory Committee [established by the SEC in 2009]. I am confident that this committee’s input will be of great value to the commission as we carry out our investor protection mandate in our rapidly changing financial marketplace.

Related Topics: Financial Industry Regulatory Authority, North American Securities Administrators Association Inc (NASAA), Securities and Exchange Commission