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CONTINUED OVERSIGHT OF THE 

SEC’S OFFICES AND DIVISIONS 

HEARING 

BEFORE THE

SUBCOMMITTEE ON CAPITAL MARKETS AND 

GOVERNMENT SPONSORED ENTERPRISES 

OF THE

COMMITTEE ON FINANCIAL SERVICES 

U.S. HOUSE OF REPRESENTATIVES 

ONE HUNDRED FOURTEENTH CONGRESS 

SECOND SESSION 

APRIL 21, 2016 

Printed for the use of the Committee on Financial Services 

Serial No. 114–84 

( 

(II) 

HOUSE COMMITTEE ON FINANCIAL SERVICES 

JEB HENSARLING, Texas, Chairman 

PATRICK T. MCHENRY, North Carolina, 

Vice Chairman 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

SCOTT GARRETT, New Jersey 

RANDY NEUGEBAUER, Texas 

STEVAN PEARCE, New Mexico 

BILL POSEY, Florida 

MICHAEL G. FITZPATRICK, Pennsylvania 

LYNN A. WESTMORELAND, Georgia 

BLAINE LUETKEMEYER, Missouri 

BILL HUIZENGA, Michigan 

SEAN P. DUFFY, Wisconsin 

ROBERT HURT, Virginia 

STEVE STIVERS, Ohio 

STEPHEN LEE FINCHER, Tennessee 

MARLIN A. STUTZMAN, Indiana 

MICK MULVANEY, South Carolina 

RANDY HULTGREN, Illinois 

DENNIS A. ROSS, Florida 

ROBERT PITTENGER, North Carolina 

ANN WAGNER, Missouri 

ANDY BARR, Kentucky 

KEITH J. ROTHFUS, Pennsylvania 

LUKE MESSER, Indiana 

DAVID SCHWEIKERT, Arizona 

FRANK GUINTA, New Hampshire 

SCOTT TIPTON, Colorado 

ROGER WILLIAMS, Texas 

BRUCE POLIQUIN, Maine 

MIA LOVE, Utah 

FRENCH HILL, Arkansas 

TOM EMMER, Minnesota 

MAXINE WATERS, California, Ranking 

Member 

CAROLYN B. MALONEY, New York 

NYDIA M. VELA ́ ZQUEZ, New York 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

MICHAEL E. CAPUANO, Massachusetts 

RUBE ́ N HINOJOSA, Texas 

WM. LACY CLAY, Missouri 

STEPHEN F. LYNCH, Massachusetts 

DAVID SCOTT, Georgia 

AL GREEN, Texas 

EMANUEL CLEAVER, Missouri 

GWEN MOORE, Wisconsin 

KEITH ELLISON, Minnesota 

ED PERLMUTTER, Colorado 

JAMES A. HIMES, Connecticut 

JOHN C. CARNEY, JR., Delaware 

TERRI A. SEWELL, Alabama 

BILL FOSTER, Illinois 

DANIEL T. KILDEE, Michigan 

PATRICK MURPHY, Florida 

JOHN K. DELANEY, Maryland 

KYRSTEN SINEMA, Arizona 

JOYCE BEATTY, Ohio 

DENNY HECK, Washington 

JUAN VARGAS, California 

SHANNON MCGAHN, Staff Director 

JAMES H. CLINGER, Chief Counsel 

(III) 

SUBCOMMITTEE ON CAPITAL MARKETS AND GOVERNMENT SPONSORED ENTERPRISES

SCOTT GARRETT, New Jersey, Chairman 

ROBERT HURT, Virginia, Vice Chairman 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

RANDY NEUGEBAUER, Texas 

PATRICK T. MCHENRY, North Carolina 

BILL HUIZENGA, Michigan 

SEAN P. DUFFY, Wisconsin 

STEVE STIVERS, Ohio 

STEPHEN LEE FINCHER, Tennessee 

RANDY HULTGREN, Illinois 

DENNIS A. ROSS, Florida 

ANN WAGNER, Missouri 

LUKE MESSER, Indiana 

DAVID SCHWEIKERT, Arizona 

BRUCE POLIQUIN, Maine 

FRENCH HILL, Arkansas 

CAROLYN B. MALONEY, New York, 

Ranking Member 

BRAD SHERMAN, California 

RUBE ́ N HINOJOSA, Texas 

STEPHEN F. LYNCH, Massachusetts 

ED PERLMUTTER, Colorado 

DAVID SCOTT, Georgia 

JAMES A. HIMES, Connecticut 

KEITH ELLISON, Minnesota 

BILL FOSTER, Illinois 

GREGORY W. MEEKS, New York 

JOHN C. CARNEY, JR., Delaware 

TERRI A. SEWELL, Alabama 

PATRICK MURPHY, Florida 

(V) 

C O N T E N T S 

Page 

Hearing held on: 

April 21, 2016 ................................................................................................... 1 

Appendix: 

April 21, 2016 ................................................................................................... 45 

WITNESSES 

THURSDAY, APRIL 21, 2016 

Butler, Thomas J., Director, Office of Credit Ratings, U.S. Securities and 

Exchange Commission ......................................................................................... 4 

Flannery, Mark J., Director, Division of Economic and Risk Analysis, U.S. 

Securities and Exchange Commission ................................................................ 6 

McKessy, Sean, Chief, Office of the Whistleblower, U.S. Securities and Exchange Commission .............................................................................................. 8 

Wyatt, Marc, Director, Office of Compliance, Inspections, and Examinations, 

U.S. Securities and Exchange Commission ....................................................... 9 

APPENDIX 

Prepared statements: 

Joint statement of the SEC ............................................................................. 46 

ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD

Sherman, Hon. Brad: 

Letter to SEC Chair Mary Jo White, dated April 18, 2016 .......................... 59 

Wagner, Hon. Ann: 

Majority Staff Report of the Committee on Homeland Security and Governmental Affairs, United States Senate, entitled, ‘‘The Labor Department’s Fiduciary Rule: How a Flawed Process Could Hurt Retirement 

Savers,’’ dated February 24, 2016 ............................................................... 62 

Garrett, Hon. Scott: 

Written responses from the SEC to questions submitted for the record ..... 102 

Messer, Hon. Luke: 

Written responses from the SEC to questions submitted for the record ..... 117 

Neugebauer, Hon. Randy: 

Written responses from the SEC to questions submitted for the record ..... 121 

(1) 

CONTINUED OVERSIGHT OF THE 

SEC’S OFFICES AND DIVISIONS 

Thursday, April 21, 2016 

U.S. HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON CAPITAL MARKETS AND

GOVERNMENT SPONSORED ENTERPRISES, COMMITTEE ON FINANCIAL SERVICES, Washington, D.C. 

The subcommittee met, pursuant to notice, at 9:14 a.m., in room 

2128, Rayburn House Office Building, Hon. Scott Garrett [chairman of the subcommittee] presiding. 

Members present: Representatives Garrett, Hurt, Royce, Neugebauer, Huizenga, Duffy, Hultgren, Ross, Wagner, Messer, 

Schweikert, Poliquin, Hill; Maloney, Sherman, Hinojosa, Lynch, 

Himes, Foster, Sewell, and Murphy. 

Also present: Representative Fitzpatrick. 

Chairman GARRETT. The Subcommittee on Capital Markets and 

Government Sponsored Enterprises is hereby called to order. Today’s hearing is entitled, ‘‘Continued Oversight of the SEC’s Offices 

and Divisions.’’ 

Without objection, the Chair is authorized to declare a recess of 

the subcommittee at any time. 

Also, without objection, members of the full Financial Services 

Committee who are not members of this subcommittee may sit on 

the dais and participate in today’s hearing. 

At this point, I will now recognize myself for 3 minutes for an 

opening statement. 

Today, the subcommittee will continue its efforts to conduct vigorous oversight of the SEC, and in particular, the individual offices 

which make up the SEC. 

In the last 2 years, our subcommittee has heard testimony from 

the Directors of the Trading and Markets, Corporation Finance, 

Enforcement, and Investment Management Divisions at the SEC. 

These hearings have allowed us to take a more thorough look at 

the agencies’ operations, their rulemaking agenda, and enforcement 

practices so that we can better understand whether the SEC is appropriately carrying out its three-fold mission to: protect investors; 

maintain fair and orderly, efficient markets; and last but certainly 

not least, facilitate capital formation. 

So I welcome our witnesses today. I look forward to hearing their 

testimony, and I hope between the four of you who are here on the 

panel that we are able to cover a lot of ground in the time we have. 

If you go back, in the year 2000 the SEC’s operating budget was 

about $369 million. Today, the SEC’s budget authority for Fiscal 

2 

Year 2016 is a little over $1.6 billion. And the SEC has recently 

submitted a request for the Fiscal Year 2017 budget coming up of 

$1.8 billion. 

So during much of the time when Congress has been accused of 

starving the SEC of funds it needs to fulfill its mission, its budget 

has actually quadrupled and has done so in less than—a little over 

a dozen years. 

It would be one thing if this four-fold increase’s funding coincided 

with an agency that has become 4 times more effective. Instead, we 

are likely to look back at this as a period of time when the SEC 

missed some of the greatest frauds in history, when it was ill-prepared for the financial crisis of 2008, and when it failed to properly 

incorporate economic analysis into its rulemaking and, more recently, has oftentimes been complicit in advancing the priorities of 

special interests. 

So, unfortunately, instead of addressing some of the fundamental 

structural issues at the SEC, the Dodd-Frank Act has created even 

more offices within the agencies, two of which are with us here 

today. Dodd-Frank also granted the agency vast new rulemaking 

authority that the SEC has oftentimes simply struggled to implement appropriately. For example, while the SEC has made strides 

towards improving the economic analysis that underlies its 

rulemakings, there is still much more work that can be done in this 

area. 

And so it is not acceptable for the SEC to simply say, ‘‘Well, Congress made me do it,’’ and therefore assume that rulemaking is 

beneficial in all cases, as the SEC recently did with its pay ratio 

rule last year. It is also incumbent upon the SEC to clearly articulate a problem, or a market failure, if you will, that the rules are 

intended to address, which should be obvious, but it is still, unfortunately, lacking in many of the Dodd-Frank rules that have been 

implemented. 

So I am eager to hear about the steps the SEC is taking to further improve its economic analysis. 

Finally, I also continue to have concerns over recent rulemakings 

related to credit rating agencies. While there is broad agreement 

that certain provisions in Dodd-Frank, such as the removal of references to credit rating agencies’ regulations, were much needed 

and directly address one of the causes of the financial crisis, I 

worry that many of the other micromanaging rules included in 

Dodd-Frank have had the effect of further stifling competition in 

the credit rating industry. 

So again, I want to thank all the witnesses for their testimony, 

and I will yield to the ranking member of the subcommittee, Mrs. 

Maloney, for 5 minutes. 

Mrs. MALONEY. Good morning, and thank you so much, Mr. 

Chairman, for holding this important hearing. I also thank all of 

our participants today. This hearing will continue our subcommittee’s series of oversight hearings on the SEC. 

Today, we are focusing on four divisions or offices in the SEC: 

the Office of Compliance, Inspections, and Examinations; the Office 

of Credit Ratings; the Office of the Whistleblower; and the Division 

of Economic Risk and Analysis, or DERA. All four of these offices 

play a critical role in policing our Nation’s securities markets. 

3 

The Office of Credit Ratings oversees the registered credit rating 

agencies such as Moody’s, S&P, and Fitch. The financial crisis revealed the importance of credit rating agencies, but physically it revealed the catastrophic consequences that can result when the rating agencies all get their ratings wrong. 

In response, Dodd-Frank created the Office of Credit Ratings in 

order to increase the level of oversight of credit rating agencies. 

One of the principal missions of this office is to ensure that inappropriate conflicts of interest at the rating agencies do not influence the ratings that the firms assign to different securities. 

The Office of the Whistleblower was also created by Dodd-Frank 

and is intended to encourage whistleblowers from the industry to 

come forward with specific and timely information about wrongdoing. In return for tips that lead to significant punishments of 

over $1 million, whistleblowers are entitled to a monetary reward, 

which incentivizes industry employees to blow the whistle before 

fraud gets too large and too devastating. 

Already, this office has received thousands of tips from potential 

whistleblowers, which is striking. In fact, in 2015 the office received over 4,000 tips from whistleblowers. 

The Division of Economic Risk and Analysis, or DERA, is the 

data arm of the SEC. It supports all of the other divisions in the 

SEC by conducting cost-benefit analysis of potential rulemakings, 

developing models that help focus the Commission’s resources on 

the riskiest practices, and even calculating the appropriate punishment for bad actors. 

Finally, the Office of Compliance, Inspections, and Examinations, 

or OCIE, is one of the largest and most underfunded offices in the 

SEC. It has over 1,000 employees who examine registered investment advisers, broker-dealers, exchanges, mutual funds, and mutual advisers. This sounds like a lot of examiners, but it pales in 

comparison to the number of market participants that the office 

has to examine. 

The office oversees more than 26,000 market participants, including over 12,000 investment advisers, 11,000 mutual funds, 4,000 

broker-dealers, 800 municipal advisers, and 18 securities exchanges. As a result, the Commission is only able to examine about 

10 percent of all investment advisers each year, which is a terrifying thought. This means that roughly 40 percent of investment 

advisers have never been examined. 

What makes this even scarier is that in 2015, a whopping 77 percent of the Commission’s examinations identified deficiencies at investment advisers, and 11 percent resulted in referrals for enforcement action. If those numbers are constant, that means that of the 

5,000 investment advisers that have never been examined, a little 

under 4,000 have deficiencies that have not been uncovered. This 

is a scary thought for investors who rely on those advisers to manage their savings. 

So I look forward to hearing from all of our witnesses today, and 

I look forward to your testimony. Thank you for your work. 

And I yield back the balance of my time. Thank you. 

Chairman GARRETT. Thank you very much. 

The gentlelady yields back. 

4 

The gentleman from Virginia, Mr. Hurt, the vice chairman of the 

subcommittee, is recognized for 2 minutes. 

Mr. HURT. Thank you, Mr. Chairman. 

And welcome, to our panel. 

I represent a rural district in Virginia, Virginia’s 5th District. It 

stretches from the northern Piedmont in Virginia to the North 

Carolina border. So as I travel across my district, I regularly hear 

from my constituents that they are concerned about jobs and the 

economy, and that they are concerned with the seemingly new normal administrative state here in Washington that makes it more 

difficult for our Main Street and small businesses to access capital 

and to be successful. 

While this committee has been laser-focused on producing legislation that would help our Nation’s small businesses thrive, that 

would ease the access to capital, and that would build upon the bipartisan success of the JOBS Act, an equally important function is 

fulfilling Congress’ duty to conduct vigorous oversight over Executive Branch agencies. 

Just as my constituents are concerned about our ever-expanding 

administrative state, I, too, am concerned that the SEC often deviates from its three-part mission: to protect investors; to maintain 

fair, orderly, and efficient markets; and to facilitate capital formation. 

Hearings such as this allow Congress to exercise its responsibility of proper oversight over how the SEC allocates its resources 

in fulfilling its three-part mission. I look forward to the testimony 

of our witnesses. 

I thank the chairman for holding this hearing, and I yield back 

the balance of my time. 

Chairman GARRETT. Great. The gentleman yields back. 

And now, I welcome the members of the panel before us. Without 

objection, your joint written statement will be made a part of the 

record. 

You will be recognized for 5 minutes. I know most of you have 

not been here before, but you know the drill, I assume. 

In front of you are the lights, which are green, yellow, and red. 

The yellow light should come on when you have 1 minute remaining, so we would ask you at that time to begin to wrap up, and the 

red light means your time has expired. 

And with that, Mr. Butler, you are recognized for 5 minutes. 

STATEMENT OF THOMAS J. BUTLER, DIRECTOR, OFFICE OF 

CREDIT RATINGS, U.S. SECURITIES AND EXCHANGE COMMISSION 

Mr. BUTLER. Good morning, Chairman Garrett, Ranking Member 

Maloney, and members of the subcommittee. Thank you for inviting me to testify on behalf of the U.S. Securities and Exchange 

Commission regarding the activities and responsibility of the Office 

of Credit Ratings. 

The office supports the Commission’s three-part mission: to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. It does this by overseeing credit rating 

agencies that are granted registration as nationally recognized statistical rating organizations, or NRSROs. 

5 

In 2006, the Credit Rating Agency Reform Act established the 

regulatory framework and gave Congress the authority to implement a myriad of rules for the oversight of NRSROs. The DoddFrank Act expanded the Commission’s authority and mandated the 

creation of an office, the Office of Credit Ratings, dedicated to the 

oversight of NRSROs. 

The office’s activities generally fall within three areas: examinations; NRSRO monitoring and constituent monitoring; and policy 

and rulemaking. 

Examinations of NRSROs for compliance with Federal securities 

laws and Commission rules accounts for the majority of the office’s 

activities. The Dodd-Frank Act requires the office to conduct an examination of each NRSRO at least annually, and the scope of the 

annual examinations covers eight required review areas. 

Further, the office employs a risk-based approach to exam planning, identifying different risks for different NRSROs. This improves the efficiency and the effectiveness of the examinations as 

resources are prioritized and focused on areas of higher risk. In addition to the annual examinations, the office conducts sweeps and 

targets examinations to address credit market issues and concerns 

and to follow up on tips, complaints, and self-reported incidents. 

The NRSROs have been responsive to the staff’s findings and 

recommendations. Many have implemented fundamental changes 

such as increasing surveillance activities; strengthening policies 

and procedures for managing conflicts of interest; adding staff to 

compliance and oversight functions; investing in multiyear technology initiatives; and enhancing disclosure, transparency, and governance. 

The annual examinations that are currently under way include 

a comprehensive review of compliance with the significant new 

rules and rule amendments that were adopted by the Commission 

in August 2014, all of which became effective by June 2015. As required by the Dodd-Frank Act, the office prepares an annual examination report summarizing the essential findings of the examinations. In December 2015, the office published a fifth annual examination report. 

The NRSRO monitoring and constituent monitoring groups within the office gather, analyze, and assess data and identify trends 

across the industry. NRSRO monitoring conducts periodic meetings 

with NRSROs and also meets on an ad hoc, proactive basis as necessary to respond to industry developments. And importantly, 

NRSRO monitoring meets with certain boards of directors, including a separate discussion with the independent directors. 

Constituent monitoring holds meetings with investors, issuers, 

arrangers, and trade organizations. The group conducts ad hoc research as warranted by industry or credit market conditions. The 

information obtained by the monitoring group provides useful input 

for examinations and for guiding the direction of any future 

rulemakings. 

The policy and rulemaking group within the office is responsible 

for developing rule recommendations, conducting studies, drafting 

reports, and including those required by the Credit Rating Agency 

Reform Act and the Dodd-Frank Act. 

6 

New rules adopted by the Commission in August 2014 address, 

among other things, reporting on internal controls; conflicts of interest, including an absolute prohibition requiring the separation of 

sales and marketing activities from analytics; procedures to protect 

the integrity and transparency of rating methodologies; a requirement for the board of directors to approve a methodology before it 

is used; and standards of training, experience, and competence for 

credit analysts. The rules also provide for an annual certification 

by the CEO as to the effectiveness of internal controls and additional certifications to accompany credit ratings affirming that no 

part of the credit rating was influenced by any other business activities. 

While the Commission has broad authority to examine all books 

and records of an NRSRO, and to impose sanctions for violating 

statutory provisions in the Commission’s rules, the Commission is 

not permitted to regulate the substance of credit ratings or the procedures and methodologies used to determine credit ratings. 

Thank you again for having me here today, and I would be 

pleased to answer any questions. 

[The joint statement of Mr. Butler, Mr. Flannery, Mr. McKessy, 

and Mr. Wyatt can be found on page 46 of the appendix.] 

Chairman GARRETT. Great. Thank you, Mr. Butler. 

Mr. Flannery, welcome to the panel, and you are recognized for 

5 minutes. 

STATEMENT OF MARK J. FLANNERY, DIRECTOR, DIVISION OF 

ECONOMIC AND RISK ANALYSIS, U.S. SECURITIES AND EXCHANGE COMMISSION 

Mr. FLANNERY. Thank you. Good morning, Chairman Garrett, 

Ranking Member Maloney, and members of the subcommittee. It is 

my pleasure to be here today to talk about the responsibilities and 

recent activities of the Division of Economic and Risk Analysis, 

which we call DERA. 

DERA supports the Commission’s mission through data-driven, 

high-quality economic analyses. Over the past several years, we 

have grown from approximately 96 employees in 2013 to a projected workforce of 175 by the end of this fiscal year. 

By that time, we anticipate employing 88 Ph.D.s, mostly in economics or finance, but also some accountants, and we even have 

two Ph.D. physicists. These Ph.D.s will be supported by 22 research associates by the end of the year. DERA staff also includes 

a diverse team of other technical experts and professional staff. 

The division’s rapid growth and resultant depth of expertise has 

allowed DERA to expand its support across an ever-increasing 

range of Commission activities. 

Our most well-known function is to provide economic analyses in 

support of Commission rulemaking and other priority initiatives. 

DERA economists examine the need for regulatory action, analyze 

the potential economic effects of the proposed and final rules, and 

evaluate public comments on those rules. 

We provide theoretical and data-driven economic analyses of potential new policies and changes to existing policies. We work closely with staff from elsewhere in the Commission from the earliest 

7 

stages of policy development through the finalization of a particular rule. 

In the course of assisting other divisions and offices, staff routinely prepares White Papers, or staff studies—White Papers and 

other documents that present novel economic analyses of specific 

policy issues or rulemakings. For example, last year DERA staff 

produced White Papers relating to the liquidity requirements for 

open-ended mutual funds’ operation, the funds’ derivative usage, 

voluntary clearing activity in the single-name credit default swap 

market, and another paper on the market for unregistered security 

offerings. 

In addition to research performed in conjunction with particular 

rules, DERA staff regularly published their research in refereed 

journals, and staff papers are posted on the DERA webpage to provide the public with access to our current research on financial 

markets. 

DERA’s analytical capabilities extend not just to rulemaking, but 

also to risk assessment. We provide financial and risk modeling expertise to other divisions and offices in support of their supervisory, 

surveillance, and investigative programs. Our data analysis helps 

SEC staff with examination prioritization and scoping, including 

providing guidance on which entities to examine and what to look 

for during the examinations. 

One example is our broker-dealer risk assessment tool, which 

was developed in close collaboration with OCIE staff. This tool analyzes how a firm’s behavior compares to its peers to identify anomalous behavior that might indicate risks in a broker-dealer’s operations, financing, workforce, or structure. 

We also have a new corporate issuer risk assessment tool, developed in conjunction with the Division of Enforcement, that allows 

enforcement attorneys to examine over 200 custom metrics that 

help them to assess corporate issuer risk by identifying financial 

reporting irregularities that may indicate fraud. 

We also work with the Division of Enforcement. During Fiscal 

Year 2015, DERA staff provided export assistance in over 120 new 

enforcement matters. Those staff helped identify securities law violations, quantify the harm to investors, calculate ill-gotten gains, 

and evaluate economic-based claims of the defendant. 

For cases that go to trial, DERA helps to prepare the Commission’s outside experts and to critique or challenge the work of opposing experts. In certain instances, DERA staff have recently testified on behalf of the Commission. 

None of this work can be performed without high-quality data. 

DERA, thus, acts as a central data hub for the intake, processing, 

and use of data throughout the Commission. DERA’s data oversight falls into two distinct but related categories. 

First, we work closely with other SEC divisions and offices to design data structuring approaches for required disclosures. DERA 

supports the SEC’s data collections and data usage by designing 

taxonomies, validation rules, data quality assessments, and data 

dissemination tools to facilitate high-quality data analysis. 

Second, DERA is responsible for the day-to-day management of 

many Commission databases. We routinely generate summary information and statistics, which are provided to Commission staff 

8 

within DERA and elsewhere within the Commission. We also develop and refine datasets that are purchased from outside. 

In sum, I believe DERA staff are delivering high-quality, datadriven analyses that are critical to the SEC’s mission, and we look 

forward to continuing this work in the future. 

Thank you again for inviting us, and I am looking forward to answering your questions. 

[The joint statement of Mr. Butler, Mr. Flannery, Mr. McKessy, 

and Mr. Wyatt can be found on page 46 of the appendix.] 

Chairman GARRETT. Thank you, Mr. Flannery. 

Mr. McKessy, good morning, and welcome to the panel. 

STATEMENT OF SEAN MCKESSY, CHIEF, OFFICE OF THE WHISTLEBLOWER, U.S. SECURITIES AND EXCHANGE COMMISSION 

Mr. MCKESSY. Good morning, Chairman Garrett, Ranking Member Maloney, and members of the subcommittee. Thank you for inviting me to testify on behalf of the United States Securities and 

Exchange Commission regarding the responsibilities and activities 

of the Office of the Whistleblower. 

The Office of the Whistleblower is a separate office within the Division of Enforcement currently comprised of 13 attorneys, 5 legal 

assistants, and an administrative assistant, all of whom are tasked 

to administer the whistleblower program. 

The whistleblower program was designed to incentivize individuals to provide the Commission with specific, timely, and credible 

information about possible securities law violations, enhancing the 

Commission’s ability to act swiftly to protect investors from harm 

and bring violators to justice. Under the program, individuals who 

voluntarily provide the Commission with original information that 

leads to a successful enforcement action resulting in monetary 

sanctions exceeding $1 million may be eligible to receive an award 

equal to 10 to 30 percent of the monies collected. 

One of our primary activities is to evaluate whistleblower award 

claims and make recommendations as to whether claimants satisfy 

the eligibility requirements for receiving an award. We continue to 

receive a significant number of award claims, including over 120 

claims in Fiscal Year 2015 alone. As of the end of Fiscal Year 2015, 

preliminary determinations and/or final orders have been issued 

with respect to nearly 400 claims for whistleblower awards. 

Since the whistleblower program went into effect, the Commis- sion has awarded more than $57 million to 27 whistleblowers, including more than $37 million in Fiscal Year 2015 alone. The efforts of these 27 whistleblowers have resulted in orders against individuals and companies totaling over $400 million in sanctions, including over $325 million in disgorgement ordered to be paid to 

compensate harmed investors. Because all our whistleblower award 

payments are made out of our investor protection fund, the 

amounts ordered to be returned to harmed investors have not been 

affected in any way by the awards paid to our whistleblowers. 

Thanks in part to the positive attention the program attracted in 

connection with our whistleblower awards, the number of whistleblower tips we receive has increased each year. In Fiscal Year 

2015, the Commission received nearly 4,000 whistleblower tips, a 

30 percent increase over the number received in Fiscal Year 2012. 

9 

Since the program’s inception, we have received more than 

16,000 tips from whistleblowers in every State in the country as 

well as the District of Columbia, and from individuals in 95 countries outside of the United States. Our office is also actively involved with enforcement staff in helping to ensure that employees 

feel secure in reporting wrongdoing either internally or to the Commission without fear of retaliation. 

In June 2014, the Commission brought its first enforcement action under the anti-retaliation provisions of the whistleblower program, sending a strong message to employers that retaliation 

against whistleblowers in any form is unacceptable. Through interpretive guidance and amicus briefs, the Commission has expressed 

its view that the anti-retaliation protections under the whistleblower program extend to those who report potential securities law 

violations internally, regardless of whether they separately reported the information to the Commission. 

Additionally, our office continues to assist enforcement staff to 

prevent companies from coercing their employees not to report possible wrongdoing to the Commission. In April 2015, the Commission brought its first enforcement action against a company that required its employees to sign broad confidentiality agreements in 

contravention of our Rule 21F-17(a). This rule prevents any person 

from taking any action, including enforcing or threatening to enforce a confidentiality agreement, to impede an individual from reporting information about a possible securities law violation to the 

Commission. 

Protecting whistleblowers from retaliation and safeguarding 

whistleblowers’ rights to report possible securities law violations to 

the Commission continues to be among our top priorities. In the 

less than 5 years since the implementation of the whistleblower 

program, we have demonstrated that we can and will protect the 

confidentiality of whistleblowers, take action against employers 

who retaliate against or interfere with their employees’ ability to 

report wrongdoing, and award tens of millions of dollars to whistleblowers whose information leads to successful enforcement actions. 

Given this strong track record, we expect that the Commission 

will continue to receive high-quality tips that can be leveraged to 

detect and halt fraud earlier and more efficiently. We fully expect 

that the whistleblower program will continue to be a game-changer 

in the enforcement of the securities laws to protect investors and 

ensure the fairness and efficiency of the marketplace. 

Thank you again for the invitation, and I am happy to respond 

to your questions. 

[The joint statement of Mr. Butler, Mr. Flannery, Mr. McKessy, 

and Mr. Wyatt can be found on page 46 of the appendix.] 

Chairman GARRETT. Thank you. Thank you, sir. 

Finally, last but not least, Mr. Wyatt, you are recognized for 5 

minutes. 

STATEMENT OF MARC WYATT, DIRECTOR, OFFICE OF COMPLIANCE, INSPECTIONS, AND EXAMINATIONS, U.S. SECURITIES 

AND EXCHANGE COMMISSION 

Mr. WYATT. Chairman Garrett, Ranking Member Maloney, and 

members of the subcommittee, thank you for the opportunity to disVerDate Nov 24 2008 15:26 Aug 14, 2017 Jkt 024068 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 K:\DOCS\24068.TXT TERI
10 

cuss the SEC’s Office of Compliance, Inspections, and Examinations, which we call OCIE, with you today. 

OCIE, through our national examination program, advances the 

SEC’s mission through examinations that improve compliance, prevent fraud, monitor risk, and inform policy. 

With a staff of just over 1,000 employees, OCIE has examination 

responsibility for registered entities consisting of more than 12,000 

investment advisers, 11,000 mutual funds and ETFs, over 4,000 

broker-dealers, more than 400 transfer agents, and over 650 registered municipal advisers. We also have oversight responsibility 

for 18 national securities exchanges, 6 active registered clearing 

agencies, FINRA, the MSRB, SIPC, and the PCAOB. 

Recent legislative changes, such as the Dodd-Frank Act and the 

JOBS Act, have expanded OCIE’s responsibility to include examinations of security-based swap market participants, including dealers, repositories, and execution facilities, as well as crowdfunding 

portals. Compounding the challenges in the sheer number of registrants we oversee is the continued growth in the financial markets and the complexity of market participants. In order to maximize the use of our limited staff, OCIE is in the formative stages 

of reallocating examiners to increase coverage of investment advisers. 

To meet the challenges posed by a registrant population that far 

exceeds our resources, we have adopted a risk-based framework for 

examinations, we have increased our utilization of advanced data 

analytics, and we promote compliance through transparency. We 

have adopted our risk-based framework to identify business practices or activities which may harm investors. 

We aggregate and analyze internal and external data sources to 

find operational red flags in our registrant population. This analysis enables examiners to identify higher-risk firms when selecting 

candidates for examination and in determining the areas that will 

be reviewed in the course of an examination. 

Over the past 5 years, OCIE has recruited industry experts, enhanced our technological capabilities, and increased our use of data 

analytics to further refine our risk-based program. For example, in 

the last fiscal year OCIE developed a new version of the national 

exam analytics tool, or NEAT. NEAT enables examiners to access 

and systematically analyze a year’s worth of trading data much 

faster than we ever could before. 

Our quants have also developed techniques and technologies that 

help examiners detect suspicious activity in areas such as money 

laundering and high-frequency trading. These ongoing efforts will 

further enhance and expand our capabilities to prevent fraud and 

monitor risk. 

OCIE strives to improve compliance with Federal securities law 

through greater transparency. We engage in extensive communication and outreach initiatives with the industry and other regulators. 

Through this process, we provide registrants the opportunity to 

self-assess and remediate noncompliant behavior on their own. For 

example, each year OCIE publishes our annual statement of examination priorities to inform registrants about areas that staff believes represent heighted risk and may warrant examination. 

11 

As outlined in our recent priorities, we are pursuing several key 

initiatives that are critical to the protection of investors. For example, in 2015 OCIE launched the ReTIRE Initiative, a multiyear examination effort focused on investment advisers and broker-dealers 

and the services they offer to investors with retirement accounts. 

We remain focused on retirement-based savings because retail investors are faced with a complex and evolving set of factors when 

making critical investment decisions. 

Another priority we have announced is cybersecurity. Over the 

last 2 years, we have conducted examinations to identify cybersecurity risks and assess cybersecurity preparedness among brokerdealers and investment advisers. 

As another example of our transparency, prior to initiating these 

exams we published our intended areas of focus, and after conducting the exams, OCIE published a summary of our observations. 

In 2016, we are continuing to conduct cybersecurity examinations, 

including testing and assessment of firms’ access and control 

rights, data loss prevention, vendor management, and incident response. 

The final priority I will mention is liquidity. In light of changes 

in the fixed-income markets over the past several years, OCIE is 

examining advisers to mutual funds, ETFs, and private funds that 

have exposure to potentially illiquid fixed-income securities. These 

examinations include a review of various controls including liquidity management, trading activity, and valuation policies. 

Thank you for inviting me to testify today, and I would be happy 

to answer any questions. 

[The joint statement of Mr. Butler, Mr. Flannery, Mr. McKessy, 

and Mr. Wyatt can be found on page 46 of the appendix.] 

Chairman GARRETT. Thank you for your testimony. 

And I thank all the members of the panel. 

At this point I will recognize myself for 5 minutes to begin questioning. 

I will begin over here, Mr. Butler, with regard to credit rating 

agencies. So one of the areas that there was actually bipartisan 

support on in Dodd-Frank was with regard to the removal of references to credit rating agencies, 939A. And that was an area, actually, that I worked on with Chairman Frank at the time to get 

included in the Dodd-Frank Act and remove references at NRSROs. 

And the purpose of putting that in Dodd-Frank was to say that 

investment decisions should not be, as they had been prior to that, 

relying entirely upon credit rating agencies. But we have seen since 

then, despite the removal at NRSROs in specific—in the regulations that pension funds—some pension funds are still including 

them; some pension funds are still specifically including the names 

of two of the large agencies in their investment guidelines. 

So in 30 seconds, can you say, has 939A been effective, as far as 

what the intention was here? 

Mr. BUTLER. 939A spoke with regard to the removal of references 

with regard to Federal statutes, and the SEC has actually worked, 

although it wasn’t the Office of Credit Ratings responsible for the 

removal— 

Chairman GARRETT. Right. 

12 

Mr. BUTLER. —the offices and divisions that were responsible 

completed the work there, and so all references have been removed 

from Federal statute— 

Chairman GARRETT. Right. 

Mr. BUTLER. —in the work that was done. 

Chairman GARRETT. But has that been effective? I understand 

that there are certain pension funds which are actually suing two 

of the larger credit rating agencies, saying that their opinions in 

the past were widely inaccurate on the one hand, but on the other 

hand they actually are still using them as far as their investment 

guidelines, which seems counterintuitive or perhaps opposed to 

their fiduciary duty. Would you agree? 

Mr. BUTLER. I am aware of the fact that there are pension funds, 

as well as State and local laws, that require specific references to 

credit ratings by name oftentimes, or actually by reference to ‘‘the 

big three.’’ 

Chairman GARRETT. And is that a problem? 

Mr. BUTLER. I wouldn’t necessarily characterize it as a problem. 

I would say that the 939A statute didn’t allow for us to do more, 

other than remove references within Federal statute. 

Chairman GARRETT. That is a good segue. Is there something 

more that should be done—either that Congress should be doing in 

this regard, or that the SEC can be, or should be, directed to? 

Mr. BUTLER. 939A, as I mentioned, was not within the ambit of 

what the Office of Credit Ratings oversees. That was the Division 

of Corporation Finance, Trading, and Markets, and Investment 

Management. I would be happy to take the question back— 

Chairman GARRETT. So is there anything else that we should be 

doing in this regard, in light of my opening position on this? 

Mr. BUTLER. With regard to the Office of Credit Ratings, we are 

comfortable with the authority we have with regard to examinations. 

Chairman GARRETT. Okay. Is there anything else that you would 

recommend, though, that we should be doing in light of the fact 

that funds are still relying upon them? 

Mr. BUTLER. With regard to the Office of Credit Ratings, we are 

comfortable with the authority we have. Beyond that, I really 

wouldn’t want to comment. 

Chairman GARRETT. Okay. 

Mr. Flannery, when it comes to certain issue regulations, economic benefit analysis in one form or another is conducted by the 

agency, correct? 

Mr. FLANNERY. Yes. 

Chairman GARRETT. Right. When you came to the issue of the 

pay ratio rule, that was done? 

Mr. FLANNERY. Yes. 

Chairman GARRETT. And in that analysis, did they find that—is 

it true that they found that they cannot quantify a benefit? 

Mr. FLANNERY. Yes, I think that is right. Ultimately, the justification, the benefit for the pay ratio rule was tied to informing 

investors about the possible advisability of their say on pay votes. 

Chairman GARRETT. Right. But at the end of the day, the SEC 

could not find—quantify a benefit, correct? 

13 

Mr. FLANNERY. Yes, sir. I think there is a difference between 

‘‘quantify’’ and ‘‘find’’— 

Chairman GARRETT. Okay. 

Mr. FLANNERY. —but certainly. So a lot of what we do is very 

difficult to quantify even though it is very important. 

Chairman GARRETT. So in the decision-making process of which 

regulations you will go forward to, why was this one done rather 

than other areas when you can quantify a benefit? 

Mr. FLANNERY. DERA responds to the rules as they come up, as 

they are treated by the Commission. We try to explain and clarify 

to them what the economic facets of the decision are, and then they 

are free to weigh those benefits and costs against the other considerations. 

Chairman GARRETT. Is it fair to say that this was done because 

it was a mandate of Congress, as opposed to the SEC recommending that it be done? 

Mr. FLANNERY. I believe it was a mandate of Congress. I believe 

it was in Dodd-Frank, yes, sir. 

Chairman GARRETT. And it is a ‘‘shall’’ situation as opposed to 

a ‘‘may’’ situation. But of course, there was no time limit on this, 

so within a whole gamut of things that the SEC could be working 

on, there were other areas where you could quantify a benefit, correct? 

Mr. FLANNERY. We can probably do more quantification then in 

that case, yes. 

Chairman GARRETT. Right. So is there a reason that we see in 

areas where you can quantify, the SEC goes ahead and does so, 

and where you can’t quantify, vice-versa? 

Mr. FLANNERY. We are in many ways a reactive division in the 

sense that we are asked to weigh in on a rule that is to be considered; we don’t actually control when the rules are considered. 

Chairman GARRETT. But do you make recommendations at the 

end of your report? 

Mr. FLANNERY. About the order of consideration? 

Chairman GARRETT. Yes. 

Mr. FLANNERY. No, sir, we don’t. 

Chairman GARRETT. Okay. 

Of course, my time is already up. 

The gentlelady from New York is recognized for 5 minutes. 

Mrs. MALONEY. Thank you, Mr. Chairman. 

Dr. Flannery, it is very good to see you again. And as you know, 

I am a big fan of structured data, especially the use of XBRL. It 

certainly makes it easier for investors to locate good investments, 

diamonds in the rough, and makes it easier for startups and new 

businesses, if they have a good story, to get it out and let investors 

know where they can make a good investment. 

In your testimony, you described DERA as the hub of information within the Commission, so can you talk a little bit about why 

structured data like XBRL is useful to the investor, and useful to 

the SEC, and exactly where does the implementation of it stand 

now with the SEC? 

Mr. FLANNERY. Yes. We have an Office of Structured Disclosure 

inside of DERA, and the purpose of that office is to advise where 

and what and how data should be structured. So when there is a 

14 

new rule, when there is a revised form, these folks evaluate what 

can be captured and what is the best technical way for it to be captured, of which XBRL is one good possibility. 

A good example of what that does for us, the XBRL, is we now 

publish on our website quarterly financial reports for all registrants. So we have about 8,000 registrants, and the small ones 

don’t get a lot of attention from the commercial data services, the 

commercial data providers. 

So we have a complete set of information, and that is useful to 

investors for the purposes you said. It is useful for us when we do 

a rule or when we do a risk analysis because we have a more complete and a much better grasp of the information that is most relevant to the firms that have the hardest time raising capital. So 

it is a very valuable resource for us and we provided the data to 

the public. 

One of the things about XBRL is that the data are to be filed by 

the end of the quarter, and usually within the next week we have 

those data sets up and available for people to use. 

Mrs. MALONEY. Some people say they don’t use it because there 

is no enforcement on the accuracy of the XBRL. And aren’t you dependent on what the industry hands you? 

The company hands you their data. You don’t check to make sure 

that data is correct. Is that correct? 

Mr. FLANNERY. There are various internal consistency checks 

that can be done pretty easily with an XBRL taxonomy. This 

whole— 

Mrs. MALONEY. But you do rely on the industry giving you the 

information, correct? 

Mr. FLANNERY. Yes, we do. And there has been a learning process since 2009 when we first required the largest registrants to report using XBRL. 

Mrs. MALONEY. How could you enforce the accuracy more? That 

is the one complaint that I hear from investors, that they would 

like it to be accurate and there is no guarantee that it is accurate 

so they say they don’t use it because there is no really check on 

the accuracy. How could we improve the accuracy and the enforcement of accuracy on the data you receive? 

Mr. FLANNERY. That is a primary objective of our Office of Structured Disclosure, and as I mentioned, within XBRL there are various mechanisms for at least assuring the internal consistency of 

the data. Now, if somebody files an incorrect number, whether that 

is in XBRL or it is on paper, there is nothing we can do about that 

as long as it is not inconsistent with other parts of the report. 

But our OSD people, Office of Structured Disclosure, are investigating at all times—when I said, ‘‘how the data get reported,’’ 

they are investigating how we can most parsimoniously and efficiently assure increased compliance. 

Mrs. MALONEY. They say that one of the best ways to get accurate data is, when the sale takes place on the exchange, just being 

able to capture that, as opposed to depending on private industry. 

What is your response to that? 

Mr. FLANNERY. That would be a stock sale. 

Mrs. MALONEY. Yes. 

15 

Mr. FLANNERY. Yes. And the data I have been thinking about, I 

thought you were talking about, was the financials provided by registrants in XBRL, so that wouldn’t be in the same venue. 

Mrs. MALONEY. Yes. But the stock sales. 

Mr. FLANNERY. Yes. The stock sales, we have direct feeds, and 

of course there are direct feeds that go to various private participants, but we have direct feeds. And the CAT, consolidated audit 

trail, which is to be considered by the Commission next Wednesday, I believe, will eventually make those audit trails extremely accurate and extremely detailed. 

Mrs. MALONEY. Now, how does your work differ from the Office 

of Financial Research, which is also capturing this information? Do 

you share your information with them or— 

Mr. FLANNERY. Yes, we absolutely do. The Office of Financial Research is, of course, responsible to the FSOC, and we have collaborated with them on a couple of important data sets. One is Form 

PF, which is hedge fund data—very confidential data but very valuable data. The other is money market mutual fund data. They 

have been involved in helping us design taxonomies, and we look 

forward to continuing a fruitful relationship with them. 

Chairman GARRETT. I thank you. The gentlelady’s time has expired. 

And we are going to be coming up on votes. I am going to try 

to keep things within time, so Mr. Hurt is now recognized. 

Mr. HURT. Thank you, Mr. Chairman. 

Mr. Flannery, I have some questions for you. As you know, the 

President signed Executive Order 13579, that required all agencies 

to perform an analysis of rules that may be outmoded, ineffective, 

insufficient, or excessively burdensome, and to modify, streamline, 

expand, or repeal them in accordance with that which has been 

learned. 

It seems to me your division is uniquely qualified to perform research for the SEC, and that is the purpose of your division, correct? 

Mr. FLANNERY. It is certainly one of the purposes, yes. 

Mr. HURT. Has your division participated in any of these retrospective reviews, so to speak? 

Mr. FLANNERY. We are committed under the Regulatory Flexibility Act to examine existing rules, as you know. They usually get 

examined after about 10 years after their instance, and we do that 

in conjunction with the General Counsel’s Office. 

I think rather than taking credit for finding potential things that 

can be improved in these rules, I should share it with some of the 

other divisions, because a lot of information comes into the other 

divisions from the industry, either in the form of inquiries or complaints. And there are frequently things that can be—where the 

burden can be reduced by staff guidelines, by no-action letters, and 

a lot of the kinks, if you will, that might be in an initial rule can 

be worked out that way, by staff interaction with the registrants. 

Mr. HURT. But since the President signed this order, can you 

think of any example in which a rule has been repealed, such as 

it is, because it was excessively burdensome, ineffective, or outmoded? 

16 

Mr. FLANNERY. I can give you an example of a proposed rule in 

the mutual fund space that is based on a need for better information and a reduction in the frequency of reporting, and that would 

have to do with what we call N-PORT, which is the mutual fund 

asset composition reports that are going to be filed if the rule is 

approved. So we were trying to take advantage of better information, tagging the data, and we were trying to reduce the burdensomeness of the— 

Mr. HURT. And that was done through staff— 

Mr. FLANNERY. Yes. 

Mr. HURT. —guidelines? 

Mr. FLANNERY. Yes, with— 

Mr. HURT. But again, just to be clear, there—you know, modify, 

streamline, expand, or repeal. There is not an instance that you 

can think of where a rule has been repealed based on this analysis 

that is taking place in the agency? 

Mr. FLANNERY. I cannot remember one, no, sir. 

Mr. HURT. All right. 

Another question that I have deals with the issue of regulations 

that are developed, some pursuant to Dodd-Frank, with joint participation from individual agencies. And obviously, there is a requirement of review by your office, in terms of cost-benefit analysis, 

the economic impact, economic effects of these rules. 

But there are some who suggest that when it is a joint rulemaking, that cost-benefit analysis is not required. What is your 

take on that, and have you all had pushback from the other agencies that you have had to develop rules with on that specific issue? 

How do you deal with that? 

Mr. FLANNERY. Yes, of course, you are right. We have a securities 

law requirement that we consider, among other things, efficiency, 

competition, and capital formation, which is unique to the SEC. So 

there are instances where we will do a joint rule, most often with 

the banking regulators, and ours will be the only economic analysis. 

There is one that we are involved in now where we— 

Mr. HURT. So is the analysis that you do used in the promulgation of the rule in the process? 

Mr. FLANNERY. Yes. We do an analysis as it affects our registrants because, of course, the rule that we promulgate affects 

only— 

Mr. HURT. The banking regulators don’t do that. 

Mr. FLANNERY. I believe that is correct. They are not required. 

I don’t know what they do inside, but they are not required to put 

an economic analysis out with the rule text for public comment. 

Mr. HURT. Do you see a problem there, where you have extensive 

work done by your agency evaluating the costs and benefits on your 

side as it relates to your registrants, but not as it relates to those 

who are regulated by the other agency? Is that a problem? 

Mr. FLANNERY. I don’t know whether there is a problem in that 

regard. What I know is that we have different statutory and regulatory constraints that we operate under. We have developed our 

guidance on economic analysis to take advantage of our specific expertise and to take—and to fit with the specific institutions and 

parts of the capital markets we work with. 

17 

Mr. HURT. Okay. 

Mr. FLANNERY. Whether that should transplant elsewhere is beyond my expertise. 

Mr. HURT. Okay. 

Thank you. My time has expired. 

Chairman GARRETT. Thank you. 

Mr. Hinojosa is now recognized for 5 minutes. 

Mr. HINOJOSA. Thank you, Mr. Chairman. 

My first statement is to thank you and to thank our distinguished panel of witnesses for their appearance and testimony 

today. 

My first question is to Mark Flannery. 

Mr. Flannery, as you are aware, the Department of Labor issued 

a rule earlier this month regarding the fiduciary standard of care 

that is owed to investors when providing them personalized investment advice about their retirement accounts. This standard of care 

ensures that financial advisers providing advice act in their client’s 

best interest. 

Chair White has publicly stated that she would like the SEC to 

implement its own fiduciary duty rule. My question to you is, has 

the SEC studied whether conflicts of interest in the provision of investment advice hurts investors? 

Mr. FLANNERY. As you say, this is a major objective of the Chair, 

and she has people in Trading and Markets who oversee brokers 

and dealers; she has people in I.M., Investment Management, who 

oversee registered investment advisers; and staff from DERA, collaborating on developing a rule. For reasons that surprised me very 

much because I was new to the SEC, that turned out to be a very 

difficult problem. It is taking a long time to get it right, and we 

want to make sure that we get it right when we get something out. 

Mr. HINOJOSA. This committee has considered bills that would 

impose a cost-benefit analysis on the SEC, and I believe these bills 

would favor industry over investors and open the SEC up to increased litigation risks. Can you please describe all of the economic 

analysis obligations that the SEC undertakes when it looks to propose a new rule or an amendment to an existing rule? 

Mr. FLANNERY. Yes. As I said, we have a 15- or 20-page document that we refer to as the ‘‘guidance,’’ which is about 4 years old 

and lays out the content of what should go into an economic analysis at the SEC. 

The first thing we do is we establish what is called a baseline. 

We try to document what is the state of the market, what is the 

state of the affected players if we don’t introduce the rule. 

So we start with a baseline. We spend a lot of time trying to document that with statistics. And that gives everybody involved in 

the discussion an opportunity or perhaps an obligation to work off 

of the same baseline. 

Then, we are interested in identifying who will be affected by the 

rule, who is likely to be affected by the rule, and what would be 

the benefits and costs to the various people who are affected, the 

various firms and individuals. 

One of the things that we find is that there are many cases 

where we cannot quantify a benefit, so I would love for someone 

to explain to me how, for example, I could quantify the benefit of 

18 

a more informed investor. I know it is positive, but I don’t know 

how big it is compared to a dollar. 

Mr. HINOJOSA. I can’t answer your question, but I am very much 

in favor of that rule that the Secretary of Labor has recommended 

and has had hearings on for a long time, and that I think would 

certainly help investors. 

My next question is to Mark Wyatt. 

Mr. Wyatt, the Office of Compliance, Inspection, and Examinations completed approximately 2,000 examinations by 11 regional 

offices. Is the current agency budget sufficient to keep pace with 

the increasing number of examinations that need to be conducted? 

Mr. WYATT. We certainly are trying to use our limited resources 

as effectively as possible. We are trying to endeavor to increase our 

examinations. Last year, Fiscal Year 2015, was a 4-year high for 

the examinations. 

That said, we are striving to conduct additional examinations 

and increase our coverage in the investment adviser space, which 

currently is around 10 percent. On the broker-dealer side, together 

with FINRA, we get to roughly 50 percent of those registrants. 

So we certainly welcome additional resources and information 

that can help us develop our exam program and our risk-based program to conduct further exams. 

Mr. HINOJOSA. How do the SEC’s resources to examine registrants compare to the resources of some of the large broker-dealers, banks, or other public companies that the SEC is supposed to 

hold accountable? 

Chairman GARRETT. Very quickly, please. 

Mr. WYATT. OCIE has 1,011 examiners. There are some large 

global registrants who have over 3,000 alone in their compliance 

program—for a global compliance program, I will highlight. 

Mr. HINOJOSA. Thank you. 

I yield back. 

Chairman GARRETT. The gentleman yields back. 

Mr. Royce is now recognized. 

Mr. ROYCE. Thank you, Mr. Chairman. 

And thank you, to the witnesses, for joining us today. 

Experts have deemed the United Kingdom’s retail distribution 

review as being effectively identical to the Labor Department’s 

rule. In the eyes of not just industry but the British government 

itself, implementation of that RDR review created what they called 

an advice gap that locked out middle- and lower-income savers 

from investment advice. 

And I have studied the Johnson report about the Department of 

Labor’s communications with the SEC during the lead-up to the 

rules release. I share the Senator’s frustration with the Department’s lack of cooperation in releasing all of its communication 

with the Commission regarding its rule. 

So I am just going to ask Mr. Flannery, did the DOL and the 

SEC communicate about the impact of Great Britain’s RDR on 

British consumers? And if so, to what extent? And if not, why did 

the SEC not think it relevant to reference the fact that a developed 

economy has already implemented a rule similar to the DOL’s rule 

and this was no longer a hypothetical situation? 

19 

Mr. FLANNERY. The retail distribution review, which I think took 

effect at the beginning of 2013, we viewed—in the SEC, we viewed 

that as an extraordinarily interesting policy step. We could call it 

an experiment because it didn’t involve us. 

I undertook a couple of conference calls with people over in the 

regulatory agencies there. With me on those conference calls was 

one of my staff who was involved in dealing with the Department 

of Labor economists, so we certainly conveyed that information to 

them. 

I don’t know in what form. I am not familiar with the details. 

But certainly, the information was conveyed through that individual. 

Mr. ROYCE. But information coming back the other way about 

the advice gap that they were experiencing in Britain with middleincome and lower-income savers from investment advice—that information was being collected or— 

Mr. FLANNERY. It was certainly conveyed to the Department of 

Labor. When we are asked to provide technical advice to any organization, we provide technical advice based on our expertise with 

our institutions and our space. 

So if we send over comments or suggestions, those people are operating in a different regulatory environment under different legislation, and it is therefore their decision which of our comments is 

most appropriate to their situation. 

Mr. ROYCE. I was going to ask Mr. McKessy a question, and this 

goes to the issue of the office’s creation under an amendment that 

I offered in this committee. It came as a result, actually, of Harry 

Markopolos’ struggle, which he explained to us, his decade-long 

travail to bring Bernie Madoff’s Ponzi scheme to the attention of 

the SEC, and in particular, his frustration year after year after 

year about the failure of the SEC to take any action against Bernie 

Madoff. 

So the idea in a nutshell was that by establishing a separate office within the Commission, the SEC would be better situated to 

protect whistleblowers and ensure that their concerns are, in fact, 

acted on and not handled as that previous situation was. 

Do you think the new structure is working? And what could be 

done to improve it? 

And I am also concerned that not unlike the gaps in coordination 

we had between regional offices and divisions in the SEC before 

your office was created, there may be gaps in coordination with 

other parts of the government. How does your office coordinate 

with other Federal agencies that allege conduct that is beyond the 

SEC’s jurisdiction? That is the thrust of what I am concerned 

about. 

Mr. MCKESSY. I think the creation of the Office of the Whistleblower—by the way, I am very grateful for it because it created my 

job—has been effective in encouraging whistleblowers to come forward. I certainly have had a number of meetings now with Mr. 

Markopolos and gathered his thoughts on how we can be as effective in advocating for whistleblowers. 

I think beyond the Office of the Whistleblower, there are other 

structure changes in the agency that have been effective in dealing 

with issues like information gaps. The creation of the Office of 

20 

Market Intelligence, which is the centralized office that centralizes 

all the intelligence that comes into the agency to make sure that 

when we get a tip from a whistleblower, if it is related to something that somebody is already looking at, that it finds the right 

home and that we don’t have competing offices working on the 

same matter. 

And at the end of the day, I think the fact that the Whistleblower Office provides three benefits to whistleblowers—confidentiality, anti-retaliation protections, and the ability to be paid—has 

created real incentives to allow people to come forward if they otherwise were unwilling to or reluctant to. I think we are seeing the 

results of that in the fact that we have solicited over 16,000 tips 

since the program went into effect. 

Mr. ROYCE. Good. 

Thanks again, Chairman Garrett. Thank you. 

Chairman GARRETT. The gentleman’s time has expired. 

The gentleman from Massachusetts is recognized for 5 minutes. 

Mr. LYNCH. Good morning, and thank you, Mr. Chairman. 

I want to thank the witnesses for their help on this issue. 

Mr. Butler, I was a member of this committee during the financial crisis going back to 2008, and I think it is beyond any reasonable doubt that the rating agencies played an important role as a 

facilitator of that crisis, and they not only amplified the intensity 

of the crisis, but also, I think, facilitated the wider scope of that 

crisis, as well. 

And independent researchers and investigators as well as the 

Justice Department have basically said that the sort of pay-to-play 

role or system that has been in place, where customers pay for ratings and that the conflict of interests on the part of the rating 

agencies contributed greatly to the problems we had back then, and 

that model has to change. 

Now, since the crisis, your agency hasn’t instituted any fundamental changes in the credit agency business model that created 

those conflicts of interest, and credit rating agencies have returned 

to record profits. Your own most recent examinations, however, 

found severe failures by major credit agencies to comply with their 

own stated policies and procedures. 

Yet, you have not levied any fines or penalties on rating agencies. You have not used your statutory authority under Section 15E 

of the Security Exchange Act to suspend agencies or individuals 

from ratings. 

And the Office of Credit Ratings’ public examinations do not even 

identify the specific rating agencies that violate procedural rules. 

You don’t even call them out. No name and shame. 

It seems to me that the system is designed really to shield the 

rating agencies from any accountability. We don’t even identify the 

people. We use terms like, ‘‘one of the larger rating agencies,’’ 

which I assume is one of the big three. 

Your testimony states that the OCR attempts to serve the public 

interest and protect users of credit ratings, but I have to ask you, 

do you really believe that we can get to that place without eliminating the conflict of interest that currently exists where companies pay the rating agencies for favorable credit ratings, and that 

the companies are in competition with each other? 

21 

There is a great segment in, ‘‘The Big Short,’’ that movie, where 

they are talking to one of the folks from Standard & Poor’s and the 

analyst asks, ‘‘Why aren’t you tougher or more demanding on these 

guidelines?’’ 

And the woman from Standard & Poor’s says, ‘‘Well, if we do, 

they will just go to Moody’s.’’ That sort of encapsulates the problem 

here. 

So what is the answer here? As long as we have that conflict of 

interest, are we ever going to get to a place where we are actually, 

as your mission states, going to be able to protect the users of credit ratings? 

Mr. BUTLER. In my estimation, compliance is not a destination 

but it is a journey, and we are well along on that journey with regard to the rating agencies and infusing in them the importance of 

compliance, enhanced governance, transparency, training, and 

other methods to build rigor within the rating process and to establish integrity. 

To address specifically your question with regard to the issuer 

pays conflict, in August 2014 the Commission adopted a new set 

of rules, and the rules were effective fully in June 2015. Importantly, within that set of rules there is a requirement for a complete separation of the sales and marketing function from the analytical function, and that is accomplished by prohibiting rating analysts or developers of methodology from participating in sales or 

marketing activities or from being influenced by other business 

considerations. 

And apart from the prohibition— 

Mr. LYNCH. Let me just stop you there because I only have 30 

seconds left. Your report says that they are departing from their 

own policies and that they are not following their own programs, 

and those companies are not being held accountable under your 

system, the one you have right now. And that is after this last 

iteration of changes has gone forward. 

They are still paying for ratings. The rating agencies know where 

their deals flow comes from, and they are acting accordingly. I 

don’t see any changes here compared to what we were doing before. 

Chairman GARRETT. I thank the gentleman for his questions, and 

I would ask everybody not to end with a question since we are trying to get in before the vote is called. 

Mr. Hill is recognized for 5 minutes. 

Mr. HILL. Thanks, Mr. Chairman. 

And I thank the panel. Thanks for your service at the Commission. 

Dr. Flannery, I took a question you answered a few minutes ago 

about the DOL rule and your work and the Chair’s commitment to 

a fiduciary rule at the Commission. The SEC has 80 years of experience in overseeing broker-dealers and investment managers and 

doing economic analysis on that, and you made the statement that 

it is really, really hard to get it right. 

And obviously, this was something that the Commission was 

asked to study back in 2010 as a part of Dodd-Frank. And yet, the 

Department of Labor has rushed into this rule—not rushed; that 

is not fair to the DOL, because they have worked on it for 2 or 3 

years. 

22 

But my biggest complaint about the fiduciary rule is that it 

wasn’t done in conjunction with the Commission and the Commission didn’t take the lead on it to get it right on behalf of all market 

participants. 

Since it is hard, what do you think are the hardest things about 

it when you look at it from an economic, analytic point of view of 

trying to ‘‘get it right?’’ Obviously, FINRA and the SEC have led 

the way in designing suitability standards and best interest standards, and if we manage money on a discretionary basis, it is subject 

to a fiduciary standard in the industry. So what do you rank as the 

most difficult challenges there? You can answer that question because you are not commenting on the Department of Labor, I 

think. 

Mr. FLANNERY. No, in the context of the SEC— 

Mr. HILL. Yes. 

Mr. FLANNERY. —and in the context of combining the standards 

to which—the fiduciary standards to which broker-dealers and investment advisers have been held historically, they are different 

standards. In the old days, broker-dealers sold things to people and 

got compensated via commissions; investment advisers gave advice, 

didn’t get compensated via commissions, but got compensated via 

fees. 

Now, the broker-dealers have moved into the advice-giving space. 

And they bring with them a compensation arrangement that was 

designed and that survived in a somewhat different environment. 

So one of the first questions that comes up here is, what does it 

mean to give financial advice? If I am a broker, I have to make 

sure that the security is suitable for my customer, but after the 

customer has bought the security, I don’t have any further responsibility to monitor the customer’s portfolio. 

Mr. HILL. That is not true, is it? They have an obligation to 

make sure that the financial disclosure and their situation is reviewed at least annually in most firms’ policy manuals for net 

worth, earnings, suitability, changing circumstances, marriage, 

having children, having an estate plan. They do have a continuing 

obligation to their client, don’t they, under all policies of FINRA 

and the SEC? 

Mr. FLANNERY. I believe that the broker-dealer has an obligation 

that is transactions-oriented, as opposed to life change. So if there 

is a life change and the customer comes back, there could be a different definition of suitability. But if there is a life change and the 

customer doesn’t come back, there is no responsibility, as I understand it, for a broker to call up and say, ‘‘Hey, now that you are 

remarried you ought to do something different.’’ 

Mr. HILL. We don’t have to debate that here. I would very much 

disagree with that based on looking at firms’ policies and procedures manuals for a couple of decades. 

But what else do you think is challenging about getting it right, 

from the Commission’s point of view? 

Mr. FLANNERY. One of the things that is surprising to me is how 

difficult it is to disclose information effectively. The broker-dealer 

and the investment adviser rules and standards are based on disclosure, and there is sometimes a difference between disclosure and 

the transmission of information. 

23 

So we have, in DERA, just started a small behavioral finance 

unit to try to understand how people process information that is 

maybe second nature to those in the finance industry but new and 

confusing to those outside. 

Mr. HILL. Couldn’t the Department of Labor’s approach, though, 

of creating one set of approaches for a retirement account versus 

another set of approaches executed by the SEC and FINRA on behalf of all other account categories lead to investor confusion? 

Mr. FLANNERY. I suppose it could. Certainly, there is some inevitable confusion, I suppose, because the Department of Labor rules 

are promulgated under a different set of statutes, a different set of 

considerations than the securities laws under which we operate. 

Mr. HILL. And hence, that is why I really think that in an ideal 

circumstance the OMB, the Administration would have insisted 

that the Commission take the leadership role in harmonizing this 

approach. 

Thank you, Mr. Chairman. I yield back. 

Chairman GARRETT. Thank you. The gentleman yields back. 

The gentleman from Connecticut is recognized for 5 minutes. 

Mr. HIMES. Thank you, Mr. Chairman. 

And thank you, gentlemen, for being with us today, and for your 

good work. 

I have two questions, which I recognize are a little tangential to 

your offices and divisions, but both pertain to topics which I have 

been concerned about, what I perceive as silence on the part of the 

SEC, so I am hoping I can get at least some provisional feedback 

on these two topics. 

The first pertains to insider trading. As you all know, the 2nd 

Circuit on the Newman decision, apart from overturning two very 

high-profile insider trading convictions, put a great deal of uncertainty into future prosecutions of insider trading. 

I think we could all agree on two things. First, we now don’t 

have a good definition of insider trading, and I, for one, am a believer that if we are going to send people to jail, we should have 

pretty good statutory definitions for why we are sending them to 

jail. Second, without getting into the guts of Newman, as you know, 

the decision really was around whether a tippee can be held liable, 

unless the tippee knows of the personal benefit received by the tipper in exchange for the disclosure. 

So if I am a corporate insider and I tell you, ‘‘Hey, I shouldn’t 

be telling you this, it is probably illegal, but you could make a lot 

of money,’’ and you trade on it, so long as you don’t know that I 

have received some tangible personal benefit, you are not prosecutable. You are not liable under the Newman decision. 

So I am looking for, I guess, a little bit more clarity from the 

SEC about whether there should, in fact, be a statutory definition 

of insider trading. 

I would point out that my colleague, Mr. Lynch, and I have also 

put forward some legislation; two Senators, Senators Menendez 

and Reed, have put forward legislation. But I am looking, I guess, 

for a little bit more guidance from the SEC about whether the uncertainty introduced by Newman is, in fact, a problem that we 

should address. 

24 

Mr. MCKESSY. I believe as the only member of the Enforcement 

Division, I am probably the best-qualified to talk about this. But 

that beingsaid, I think the Newman decision raises issues that are 

extraordinarily nuanced, and I think—I want to be as helpful as 

I can, but I think to get a real appreciation for the considerations 

that go into how Newman affects our Enforcement Division and our 

ability to bring insider trading cases is best addressed by someone 

who has more background in that. 

And, of course, I would be happy to take any questions back and 

have the right person get back to you. Obviously, we are well 

aware of the Newman decision and the nuances of it, but I think 

you probably would be better served by hearing from people who 

more appreciate the nuances of how it impacts our enforcement efforts. 

Mr. HIMES. I appreciate that. I recognize this isn’t exactly the 

panel that is right on point for that. 

I am sensing a certain amount—and I understand this. We have 

a vast body of case law associated with insider trading; we have 

a lot of ambiguity that stems from no direct statutory definition of 

insider trading. 

I would really appreciate it if the Commission would, in fact, 

focus on nuance and getting us a more clear message and maybe 

try to get away a little bit from what is bureaucratic—or what is 

case law tradition and maybe a little bit of bureaucratic inertia. 

Because again, under the example that I gave on the question of 

tipper to tippee liability, at some level, yes, it is nuanced, but at 

some level, it is also kind of common-sensical. 

Second question: We have been doing a lot of work on the JOBS 

Act, which I supported, and now we are sort of looking at a bunch 

of additional changes, expansions to the JOBS Act. And the whole 

idea of the JOBS Act, of course, is that young companies shouldn’t 

bear the full burden of Sarbanes-Oxley compliance. 

I have had estimates anywhere between $1 million and $2 million a year for the cost of Sarbanes-Oxley compliance, and we are 

spending a ton of time on that issue. I think that is good. 

But I can’t seem to get enough attention drawn to the odd fact 

that one of the biggest sources of cost for our young companies 

going public is a remarkably consistent gross spread of 7 percent. 

Let’s just say that the average IPO is in the neighborhood of $200 

million; 7 percent, that means $14 million in the IPO out the door. We are spending a ton of time on that $1 million or $2 million 

a year associated with Sarbanes-Oxley compliance, but I am having 

trouble sort of really understanding why we are not focused more 

on the odd fact that 95 percent of all IPOs that have occurred, at 

least in the 10-year period after 1998 to 2007 in the United States, 

95 percent had a 7 percent gross spread. Exactly. 

In Europe, there is no such clustering. And in fact, in Europe, 

IPOs’ gross spread average about 4 percent, and you almost never 

see a gross spread as high as 1 percent. 

Does that clustering at 7 percent over such a persistent period 

of time strike you as odd and perhaps worthy of investigation? 

Mr. FLANNERY. Let me try that. 

Another industry, which is not nearly so germane to the issues 

you express, but another industry that has the same phenomenon 

25 

is real estate brokers, where I believe there the number is more 

likely to be 6 percent. That has always puzzled me. 

There are some economic analyses for both of these cases about 

why this might actually be a good contract. But you can also find 

arguments that are equivalent to what is implicit in your comment, 

that maybe there is something nefarious going on. 

So you can find economic arguments on both sides. 

Chairman GARRETT. Thank you. Thank you for the question. 

Mr. HIMES. Thank you. I yield back. Thank you, Mr. Chairman. 

Chairman GARRETT. Mr. Hultgren is now recognized. 

Mr. HULTGREN. Thank you, Mr. Chairman. 

Thank you all so much for being here. I appreciate your work 

and your testimony today. 

Mr. Wyatt, Harry Markopolos, who initially warned the SEC 

about Bernie Madoff’s Ponzi scheme, recently revealed that he is 

working to uncover three multibillion-dollar schemes, including one 

that will be bigger than Madoff’s. As you know, many of the failures that allowed Bernie Madoff to continue his Ponzi scheme for 

as long as he did can be traced to the failures of OCIE examinations to connect the very apparent dots. Multiple SEC offices, including OCIE, were unaware of parallel investigations into 

Madoff’s entities. 

Do you believe the institutional changes implemented by OCIE 

since 2009 are sufficient to stop future fraud? And if not, what else 

needs to be done? 

Mr. WYATT. I do believe that the changes we made after Madoff 

have significantly enhanced our ability to detect those types of activities: the streamlining of our TCR program to ensure that there 

are no silos in the regions, as well as the connectivity that we have 

amongst the regions to ensure if we see a theme or a risk throughout we can act on it accordingly and bring the resources to bear. 

So we are continuing to run a risk-based program. Part of evaluating our risks is continuing to look for any emerging risks and 

connecting the dots, as you say, with the TCR program and other 

areas, including information gathered from other divisions, such as 

DERA. 

Mr. HULTGREN. Okay. 

Mr. Wyatt, the SEC did not and still does not have a standardized identification code that consistently identifies all the entities 

it regulates and makes connections between them. I believe the 

Madoff failure was in part a data standards failure. 

Last year Congressman Issa, myself, and a number of other 

members of this committee introduced legislation called the Financial Transparency Act to direct all financial regulators, including 

the SEC, to adopt data standards for information they collect with 

the hope of transforming the current landscape of disconnected documents into open, searchable data. In fact, the original name of the 

bill was the Madoff Transparency Act. 

This means, for instance, that the SEC would adopt the legal entity identifier to consistently identify all the entities it regulates 

and affiliations between them so in the future parallel investigations into related entities like Madoff’s will be electronically visible. 

For all information required by other laws to be made public, the 

26 

bill directs each agency to public such information as open data, 

machine-readable, and freely downloadable. 

Won’t an open data initiative like this help prevent future failures, like we saw with the Bernie Madoff scheme? 

Mr. WYATT. We certainly have adopted strategies to enhance our 

use of data analytics and to capture all the data that is available 

to us, as I mentioned, from internal and external sources. We have 

also centralized all the information we have regarding examinations, so anyone throughout OCIE can go in, look at a given registrant, see what activities have been involved in an examination 

or even a non-exam review for that registrant. 

So we are certainly applying the data analytics and would welcome anything that could give us additional insight into the activities of the registrants that we are examining. 

Mr. HULTGREN. Thanks. 

I believe we have to do better. We can do better. With incredible 

technologies and connectivity, we ought to be able to recognize this 

a lot sooner. 

Let me switch to Mr. Flannery, if I could. The Department of Labor’s proposed fiduciary rule, which was recently finalized, mentions annuities 172 times, but the regulatory impact analysis does 

not examine the impact of the rule on annuities, advisers, insurers, 

or the retirement savers using them. 

Last October, David Grim, from the SEC’s Division of Investment 

Management, testified that, ‘‘A lot of what we have been talking 

about with them’’—the Department of Labor—‘‘has been on impacts, the impacts of choices that they are making on investors.’’ 

What impact is Mr. Grim describing, and did your office conduct 

any cost-benefit analysis? 

Mr. FLANNERY. We did not directly do a cost-benefit analysis. We 

are involved in advising and providing comments—technical comments. And I’m sorry, I am not familiar with what Mr. Grim was— 

Mr. HURT [presiding]. The gentleman’s time has expired— 

Mr. HULTGREN. My time has expired. I yield back. 

Mr. HURT. —and we are getting ready to vote. 

The Chair now recognizes Mr. Foster for 5 minutes. 

Mr. FOSTER. Thank you, Mr. Chairman. 

And my questions, I guess, will be directed to Mr. Flannery. 

I would like to first and foremost congratulate you on your hiring 

of two physics Ph.D.s. As the only physicist in Congress—in fact, 

the only Ph.D. scientist of any kind—I recognize the complexities 

of things like structured financial products, the technology that is 

involved in high-frequency trading. All these are the sort of things 

where you need that kind of expertise, and I am very glad to see 

that you are recognizing that, too. 

Mr. FLANNERY. Thank you. 

Mr. FOSTER. I am also the author of the contingent capital requirements in the Dodd-Frank bill, and as someone who is widely 

credited with having invented the concept back, I guess in 2002, 

and then now we have seen it adopted really worldwide, I think, 

with what I see as a lot of success. 

You have seen, for example, the Swiss banking regulators, which 

are faced with a problem that their economy is not big enough to 

backstop the size banks that they have. They have used contingent 

27 

capital to make those viewed as very solid counterparties, even in 

contemplated times of financial stress. 

We have seen the whole Deutsche Bank ongoing saga where 

Deutsche Bank is aggressively restructuring, deleveraging, cutting 

bonuses, and so on, driven in large part by the worries that the 

contingent convertible coupons will not be paid more than a year 

away. So it is, to my mind, working very successfully at providing 

the early warning signal that is one of their main merits. 

And then finally, I guess most recently, Canada—the new government in Canada announcing that they are going to use contingent capital instruments to make sure the Canadian taxpayer is 

not on the hook if their big banks get in trouble. 

So I view this as a very successful thing, and I have continued 

to try to get them adopted, which they have full regulatory authority but we are not seeing very aggressive adoption. So I was wondering if you could just give your take on what you see as the lessons learned in the worldwide thing and the way forward for potentially getting those lessons used in the United States. 

Mr. FLANNERY. First of all, it is a pleasure to meet you. Contingent capital is something that I personally, and in my academic career, spent a fair amount of time talking about. 

I think you put your finger on what I view to be the biggest advantage of contingent capital instruments, which is that rather 

than wait until the last minute when a firm is close to insolvency, 

contingent capital instruments address that possibility, keep us 

away from that possibility, and give the managers and the shareholders of the firm an incentive to stay away from certain trigger 

points. 

When I first started talking about this, the crisis was fresh in 

our minds, and people who had this vision that capital would be 

almost zero, then there would be a conversion. But by the time capital is almost zero, all sorts of bad things have started to happen 

to these firms. 

I am sure you are correct when you say that they could be permitted as part of the capital stack in the United States. They 

haven’t been, and I think there are people who feel that higher capital—formal equity requirements are safer, more protective than 

contingent capital requirements are. And then how one comes out 

on that is based on how one—what one believes is the effect of 

higher capital requirements on the operation of the firm and the 

pricing of its products. 

Mr. FOSTER. Do you think at this point there are good examples 

of trigger mechanisms that have proven workable in times of 

stress, or is that still an ongoing experiment? 

Mr. FLANNERY. I believe that is a problem. The securities in Europe and Asia that have been so successful have book value trigger 

mechanisms, and one of the characteristics of firms that get into 

trouble is that their market value deteriorates much more quickly 

than their book value does. In other words, the market loses confidence in the firm despite the fact that it may be showing strong 

book-capital relations. 

And so the triggering of these CoCos, contingent capital instruments, off of book capital ratios, I view as sort of problematic and 

likely to interfere with their value. 

28 

Mr. FOSTER. And are there issues just related to the SEC, how 

they would be registered under the 1933 act, or are those—if you 

go to the European websites with the thought of investing in contingent capital, there is this big warning, as if you are a U.S. citizen, forget it. And I was just wondering if there is a clear regulatory path or whether you would see SEC issues involved in making these widely used? 

Mr. FLANNERY. I am not aware of any considerations actively 

going on inside the SEC, but it would focus on disclosure of the 

risk so that investors could understand what was likely to happen 

and accept the risks for the compensation they are being given. 

Chairman GARRETT. I thank you. The gentleman’s time has expired. 

Mr. Duffy is now recognized. 

Mr. DUFFY. Thank you, Mr. Chairman. 

Welcome, panel. It is great to have you here. 

I am just a warm-up act for Mrs. Wagner, who is going to go in 

a second on the DOL fiduciary. Obviously many of us, as you are 

well aware, have concerns about the rule. And it is my understanding that the SEC also shared some concerns about the proposed rule and now the actual rule. 

Mr. Flannery, is it fair to say that the Department of Labor, for 

the most part, disregarded much of the advice that the SEC gave 

to them in regard to this rule? 

Mr. FLANNERY. The advice that was given, I think of it more as 

technical comments. Some of it was incorporated into the final rule 

and some was not. I don’t know about the preponderance. 

Mr. DUFFY. Okay. 

One of our concerns, for example, would be that one of your 

economists suggested that the Department of Labor should measure improper activity of advisers through measuring conflict of interest, the proposed—or the purpose of the rulemaking process, not 

projected investment returns. And it seems like the DOL didn’t 

take that advice. Is that fair to say? 

Mr. FLANNERY. I am not familiar with the final DOL rule. It is 

395 pages and I look forward to reading it, but I haven’t yet, so 

I can’t be sure. 

Mr. DUFFY. Have you undertaken any analysis of the impact of 

this rule on investors? 

Mr. FLANNERY. We have not yet gotten to that point because our 

internal deliberations—again, in a different securities space—have 

not gotten to the point of generating a rule. So we have not yet 

done that sort of economic analysis. 

Mr. DUFFY. Tell me if you share my concern, because I come 

from central, western, and northern Wisconsin—not a really 

wealthy part of the world. We don’t have a lot of people who have 

$500,000 or $750,000 in their retirement accounts. We have people 

who have $30,000 and $50,000 and $80,000 in their retirement accounts. 

There is some concern that we are going to migrate those folks 

from getting advice from someone that they have worked with and 

that they know and trust to a different computer model: the roboadviser. Do you foresee that happening, as well? 

29 

Mr. FLANNERY. I think you can look at the robo-adviser in the 

way you have. You can also look at it as an opportunity for people 

who are just getting into retirement savings, people who are generally more comfortable taking advice from computers than I might 

be or you might be. 

Mr. DUFFY. So let’s actually play that out a little bit, because it 

might not be just the person who just started to invest. Now, the 

first-time investor in Washington, D.C., might start after a couple 

of years and have $80,000 in their retirement account; but in my 

community, it is after 25 years, they have $80,000 in their account. 

And maybe this is open to the panel—do you think that maybe 

someone who is not an expert in investing, their life focus has been 

elsewhere but they have been responsible, they have put a little bit 

of money away—do you think that, say, look back to last August, 

that that person, when the markets start to move, is going to be 

more compelled to look at their computer screen and make the 

right choice as opposed to calling their investment advisers and 

trying to sell their investments and their adviser is going to say, 

‘‘Whoa, hold on a second. Whoa, whoa, whoa, whoa, whoa. That is 

not the right call right now. We should actually ride out this storm. 

That is not part of our plan. We know there are peaks and we 

know there are valleys. We ride it out. Don’t sell.’’ 

Are they going to get the same advice from the computer? And 

I guess my question is, aren’t they going to make really bad choices 

for their future if you have a robo-adviser as opposed to a financial 

adviser? 

Mr. FLANNERY. I suspect that there were a lot of people in the 

world in Wisconsin who didn’t even know what was happening that 

day, didn’t look at their financial statements. In general, I agree 

with you entirely that good financial advice is valuable. I think 

that good financial advice also sometimes comes with conflicts, 

and— 

Mr. DUFFY. I don’t dispute that, but does good financial advice 

come from a computer? 

Mr. FLANNERY. I don’t know enough about those computers so I 

can’t tell you that. 

Mr. DUFFY. If I am able to get 8 or 10 questions about some of 

my goals, some of my income, how many kids I have, what I want 

at retirement, I put it in and it hits an algorithm and it spits out 

some advice, do you think that just because I am a low-income individual, I am a low-dollar saver, that I shouldn’t be entitled to the 

advice that comes from someone who makes $800,000 a year? 

Mr. FLANNERY. I guess we don’t know—certainly the point you 

make is widely discussed—for a fact what is going to happen. 

Mr. DUFFY. So do you have a study in the works so that we can 

know? 

Mr. FLANNERY. We will know when we take up a rule at the 

SEC— 

Mr. DUFFY. And isn’t it too late? Isn’t it too late? Because my 

people are already going to be kicked out of personal advice and 

they are going to be relegated to their computer. 

Do you share that concern? They are already out once you do 

your study and the rule is implemented. 

30 

Mr. FLANNERY. Again, the rules under which the DOL operate 

are different from those—and the legislative authorities are different from those under which we operate— 

Mr. DUFFY. I can’t wait to see how we navigate both an SEC and 

a DOL rule and how that is going to play out on the expense side 

and how— 

Chairman GARRETT. The gentleman’s time— 

Mr. DUFFY. I know. Sorry, Mr. Chairman. I yield back. 

Chairman GARRETT. The gentleman from California is recognized. 

Mr. SHERMAN. Thank you. 

I would point out that I think it was Congress’ intention that the 

SEC and the Department of Labor have very similar identical 

roles. It is absurd to think that IRA accounts would have one set 

of protections and non-IRA, non-pension accounts would have another. And it is even more absurd to say that the IRA accounts 

typically controlled by those in their 50s and 60s should have more 

protection than widows and widowers and elderly people who typically, in middle-class families, control the larger accounts. So I 

share some of the last gentleman’s concerns. 

Mr. Chairman, the one part of the SEC we don’t have before us 

are those concerned with accounting standards. I would like to 

enter into the record my letter of earlier this month demonstrating 

the incredible harm that is being done to our economy by the— 

well, the departure from accepted accounting theory that requires 

companies to write off their research and experimentation costs. 

Chairman GARRETT. Without objection, it is so ordered. 

Mr. SHERMAN. Thank you. 

Mr. Butler, we have just—we are still suffering from this 2008 

downturn. I think it was mostly caused by the credit rating agencies. 

We still have a system where the umpire is paid by one of the 

teams and selected by that team. And the SEC has decided, instead 

of being an agency that favors transparency for investors, to conceal this by such relatively meaningless so-called protections. It 

says, ‘‘Well, the sales force can’t talk to those who do the ratings.’’ 

The people who do the ratings are compensated by the company; 

their promotions depend upon the company; they want the company to be successful. Is there any rule that those engaged in rating debt obligations cannot receive stock options, bonuses, or any 

benefit from the success of a company they work for? 

Mr. Butler? 

Mr. BUTLER. Each of the companies have different compensation 

arrangements— 

Mr. SHERMAN. I asked, is there any SEC prohibition? 

Mr. BUTLER. With regard specifically to rating analysts and compensation? 

Mr. SHERMAN. Yes. 

Mr. BUTLER. I would have to take that back— 

Mr. SHERMAN. Okay. So if you give great inflation, the company 

makes money, your stock options do better, and the SEC has no 

rule of which you are aware—and if you are not aware of the rule, 

it would be very hard to think the rule is being enforced, since you 

are the one who would be enforcing the rule. 

31 

The debt markets are obviously far more important to the economy, or at least involve far more capital, than the stock markets. 

Those who invest are basically entirely dependent upon the ratings. 

Even if you know better—you are managing, say, the T. Rowe Price 

bond fund—if you decide to forgo buying a AA-rated bond that pays 

20 basis points more, then I am going to invest in Vanguard because all I am going to be able to do as an investor is decide which 

has the highest rating and the highest yield. 

I want to talk to you about one particular problem. That is the 

Peruvian agrarian reform bonds. 

Obviously, the way to make money is to try to get Peru as a client. It is a significant country. And one way to do that is to avoid 

even offering to rate these agrarian bonds that seem to be a part 

of a selective default. 

Is there any rule that says that a credit rating agency can’t 

refuse to rate bonds because they can make more money by—they 

are paid off one way or another not to rate them? 

Mr. BUTLER. I am generally familiar with the media coverage on 

the Peruvian bonds, and I can’t obviously discuss the specifics of 

a— 

Mr. SHERMAN. Is there any rule that says you can—that you enforce that would prohibit Peru from saying, ‘‘Please don’t comment 

on our agrarian bonds and we will make sure to give you a contract 

worth millions of dollars in some other part of our financial dealings?’’ Is there any rule that you can point to which prohibits that? 

Mr. BUTLER. The rules provide specifically for an absolute prohibition of rating analysts to be involved in sales and marketing activities. 

Mr. SHERMAN. This is whether you take the engagement. It 

doesn’t involve the rating analysts; it involves the sales force. 

Mr. BUTLER. The rule prohibits rating—the analysts—the analytical function from being involved in the sales and marketing function. That is achieved by prohibiting analysts from being involved 

in sales and marketing or from being influenced— 

Mr. SHERMAN. That is not what I am asking. 

Mr. BUTLER. —consideration. 

Mr. SHERMAN. The sales force decides whether to take the engagement. So if Peru pays them a few million dollars to say, ‘‘Just 

don’t even get your credit rating analysts involved; don’t let them 

look at it; don’t take the engagement—’’ 

Chairman GARRETT. He has the question. Do you have the answer? 

Mr. BUTLER. In addition to the rule, there is a required certificate to accompany each rating action that says there was no influence of the analyst— 

Mr. SHERMAN. This is a non-rating action, sir. You are avoiding 

my question and the answer is obvious. 

Chairman GARRETT. Okay. Thank you. The gentleman’s time is 

up. 

Mr. SHERMAN. I yield back. 

Chairman GARRETT. Mrs. Wagner is recognized for 5 minutes. 

Mrs. WAGNER. Thank you, Mr. Chairman. 

Director Flannery, as part of last year’s transportation bill, one 

of my bills was included that would allow small reporting compaVerDate Nov 24 2008 15:26 Aug 14, 2017 Jkt 024068 PO 00000 Frm 00037 Fmt 6633 Sfmt 6633 K:\DOCS\24068.TXT TERI
32 

nies to incorporate by reference any post-effective amendments on 

the Form S-1. The SEC, when implementing this provision in January, estimated that over 70,000 work hours and $85 million would 

be saved annually by small business. Clearly, this is a huge benefit 

for small companies. 

However, in February I wrote a letter to the SEC asking for a 

similar analysis on the effects of expanding the availability of Form 

S-3 for small reporting companies regardless of public float or exchange-traded status. This is a provision of a piece of legislation 

that I sponsored and which has been passed out of this committee. 

Unfortunately, the response that I received to my letter was wholly 

inadequate and didn’t indicate whether such a review or study 

would actually be done. 

Dr. Flannery, would you commit today to performing that kind 

of analysis of the benefits of this provision for small companies and 

providing a more detailed response? 

Mr. FLANNERY. I’m sorry, but I never saw your letter. I don’t 

know what went into the response. 

One of the things that concerns me about reducing reporting 

from small companies is certainly there is room for there to be 

waste, but there is also evidence that companies that go to the 

markets with less information are less likely to be traded, and a 

secondary market trading for stock is ultimately what companies 

would like to have if they are going to have access to capital. 

To get back to your immediate point, I have a number of current 

policy things that we need to deal with. I would be more than 

happy to consider doing that— 

Mrs. WAGNER. I would really like you to take a— 

Mr. FLANNERY. —among those things. 

Mrs. WAGNER. —a look at this. Facilitating capital formation obviously is part of the SEC’s mission, and this is a provision that 

has appeared in that SEC’s form on small business capital formation annual report several times. I think we can really find common ground here, and I would ask, Dr. Flannery, that you all commit to performing this kind of analysis. I will make sure that you 

get a copy of my original letter; I will make sure I send it directly 

to you. 

Moving on, I would like to obviously discuss the extent to which 

the SEC and the Department of Labor coordinated in crafting their 

recently finalized fiduciary rule. According to e-mail records outlined in a recent Senate report—and Mr. Chairman, I would like 

to have these entered into the record—it seems that the Department of Labor disregarded advice from the SEC, specifically regarding concerns raised by the Division of Economic and Risk Analysis. 

Chairman GARRETT. Without objection, it is so ordered. 

Mrs. WAGNER. In fact, a specific quote—and these are fascinating 

reads—from an economist at the Department of Labor states, ‘‘We 

have now gone far beyond the point where your input is helpful to 

me.’’ These exchanges between the SEC and the DOL should make 

for very interesting reading. 

From your perspective, over the past year, sir, from the proposed 

rule to the recently issued final rule, how well has the Department 

of Labor coordinated with the SEC? 

33 

Mr. FLANNERY. We certainly had opportunities to provide technical assistance. I am familiar with the e-mail you described because it involved one of my staff. 

Mrs. WAGNER. Yes. 

Mr. FLANNERY. The staffer from DOL had also been a friend and 

a professional acquaintance of this fellow for a while, so I think 

what you are seeing is the culmination of a long stream of e-mails. 

Economists can be pretty direct. If somebody says, ‘‘I understand 

what you are saying but it is not applicable to my case; I don’t 

want to hear any more about it,’’ that is kind of the way I interpret 

that e-mail. 

Mrs. WAGNER. There are others here, too. And I don’t see the Department of Labor being open to any of your advice from, I think, 

a very fine office that you run. 

And certainly, I have great concerns. I want the DERA to do an 

analysis and an impact of this DOL rule as it stands right now. Is 

that forthcoming? 

Mr. FLANNERY. When and if—and I hope it is when—the Commission considers a rule for fiduciary standards in our space, we 

will look carefully at the DOL rule because that will be part of the 

baseline. We always start with the baseline; what is in existence— 

Mrs. WAGNER. It is your jurisdiction, sir. Honestly, it is, as is 

laid out very perfectly in Dodd-Frank Section 913. And we want 

you to do your own uniform fiduciary rulemaking here. 

This is your purview, your space. You are the regulators, including FINRA. And I really encourage and would like to get a commitment that you are willing to do a cost-benefit analysis when doing 

this. 

Mr. FLANNERY. Yes. Absolutely. That is always part of one of our 

economic analyses for a rule. 

Mrs. WAGNER. Thank you very, very much. I look forward to 

working with you as we move forward. 

Mr. FLANNERY. I look forward to getting that. Thank you. 

Chairman GARRETT. The gentlelady yields back. 

The gentleman from Texas, Mr. Neugebauer, is now recognized. 

Mr. NEUGEBAUER. Thank you, Mr. Chairman. 

Mr. Butler, could you please describe the statutory requirements 

for the annual examinations for NRSROs? 

Mr. BUTLER. Yes, sir. 

The annual examination is required to cover eight specific review 

areas, and it also requires that we conduct an exam of each of the 

NRSROs registered with the SEC. The eight required review areas 

are informed by the risk assessment process that we use internally. 

The risk assessment process takes a variety of inputs: information from the prior exams; inputs from the media; inputs from the 

other offices and divisions of the SEC; as well as tips, complaints, 

and referrals that we receive on the SEC’s TCR line. The risk assessment process is then used to effectively differentiate risks by 

registrant, which are then informing the exam scoping, which allows for our exam teams to then be most effective as they go their 

examination process. 

We also have examination teams arrayed in such a way that we 

have, if you will, larger examination teams examining the larger 

34 

registrants and smaller examination teams with smaller registrants, so that we have an effective allocation of resources. 

As a result of the examinations, there is a report given to each 

of the registrants specifically identifying the deficiencies that we 

have noted, and there is also a summary report that is required to 

be put together by the office, which is assembled and reports publicly a summary of all the essential findings that we found in the 

examinations. 

Mr. NEUGEBAUER. Do you think there is room for improvement 

on the present requirements? 

Mr. BUTLER. I think we are doing a very good job and a very effective job with what we have. I also believe that we can always 

do better, which is one of the reasons why from the budget request 

we have added an additional request for two head count in Fiscal 

Year 2017 who would be used as specialized examiners, because I 

think having specialized examiners would allow for us to be able 

to go narrow and deep, specifically on particular issues that arise 

perhaps during the course of an examination, perhaps at other 

times during the course of the year. 

Mr. NEUGEBAUER. Do you think it is necessary for those exams 

to be annual and for your folks to be present? 

Mr. BUTLER. I think it is important at the stage that we are 

right now with regard to oversight of the credit rating agencies. We 

have seen real change as a result of the examinations conducted 

and real change implemented at the firms as a result of the recommendations that accompany our findings. And but for the fact 

that we are in there with the regularity that we are, I would not 

be able to sit here today and say with such conviction that there 

was real change. 

I think the annual requirement, though, is one that allows for us 

to bring a different approach each year to focus on different areas 

within the firm so that we are not going in on a predictable basis, 

but rather on a more tailored basis for a particular firm with regards to risks that have been identified to us or that we have seen. 

Mr. NEUGEBAUER. If you could scale or tailor the current requirements, what would you do? 

Mr. BUTLER. I’m sorry. Could you repeat the question? 

Mr. NEUGEBAUER. If you could scale or tailor the current structure, what would you do? 

Mr. BUTLER. I am comfortable with the structure as it is currently crafted. 

Mr. NEUGEBAUER. And, Mr. McKessy, the written statement 

notes that your office authorized to award whistleblower is in the 

range of 10 to 30 percent. Why is the threshold not zero? 

Mr. MCKESSY. I think if the intention is to incentivize individuals to come forward if they are aware of wrongdoing, I think if— 

the calculus that individuals go through to decide whether they are 

going to report something to a regulator is very complicated and 

has a lot of factors, and amongst them, I think, is, ‘‘How much is 

in it for me?’’ or could be, ‘‘How much is in it for me?’’ 

And if it is true that when a person is making the calculus of 

whether they should approach a regulator, one of the outcomes 

could be that they get zero, that could change and affect negatively 

their incentive and their enthusiasm about coming forward. And 

35 

so, I think it is appropriate to not have zero as the baseline so that 

individuals who may otherwise be reluctant to come forward know 

that there is at least a possibility of some monetary award. 

Mr. NEUGEBAUER. What is the current value of the whistleblower 

fund? 

Mr. MCKESSY. Just over $400 million. 

Mr. NEUGEBAUER. $400 million? 

Mr. MCKESSY. Correct. 

Mr. NEUGEBAUER. What kind of internal controls do you have in 

place with respect to that fund? That is a pretty sizeable amount 

of money. 

Mr. MCKESSY. We can only make payments when the Commission approves it, and there is a process by which we pay only 

against what we can confirm has been collected. And so we have 

internal controls to make sure that the cases that have been 

deemed to be worthy of an award, we have the documentation requirements; that we receive documentation either from the court or 

from the appropriate person inside the SEC to verify that we have 

actually collected the money, and then we multiply that against 

what the percentage that the Commission has approved. 

Mr. NEUGEBAUER. Does the SEC Inspector General or the Government Accountability Office (GAO) audit those funds? 

Mr. MCKESSY. Yes. On an annual basis, the GAO audits the investor protection fund. 

Mr. NEUGEBAUER. Thank you. 

Mr. Chairman, I yield back. 

Chairman GARRETT. The gentleman’s time has expired. 

We have been called for votes. We have 5 minutes left on the 

vote, so Members should run over. This is on passage of the bill. 

I think there are only two votes, if I am not mistaken, and I believe there is one or perhaps two other Members who were here 

and will be returning after votes for final questioning. The subcommittee is adjourned, to be reconvened immediately after votes. 

[recess] 

Chairman GARRETT. Good afternoon. I hope you appreciated your 

little break. 

The subcommittee is called back into session, and at this time I 

recognize the gentleman from Pennsylvania for 5 minutes. 

Mr. FITZPATRICK. Thank you, Chairman Garrett, for permitting 

me to participate in this hearing. 

This is a really important hearing, SEC oversight of the credit 

rating agencies and the United States Congress oversight over the 

SEC, especially as it relates to consumer protection. Because each 

of the witnesses in their opening statements pretty much indicated 

one of the foundational principles of, whether it is the whistleblower section, Office of Credit Rating Agencies, and investor protection is sort of central to what you do. 

I have been following a couple of issues that are the subject of 

the hearing today. 

The first actually slightly separate issue has to do with foreign 

companies that somehow get listed on the stock exchanges of our 

Nation. They end up being fraudulent companies, many of them 

Chinese companies. We then find out that they are nothing but 

shell entities. A lot of U.S. investors have been hurt significantly. 

36 

I am not going to ask the members of the panel to address this, 

but with the chairman’s permission I would like to write to the 

members. I will do it through the chairman’s office. I am concerned 

that either the SEC and/or the United States Congress or us working together are not doing enough to protect investors, and so I 

want to follow up on that issue. 

But today, I want to follow up on the issues that were raised by 

Mr. Lynch and Mr. Sherman. Mr. Lynch is concerned, as am I, that 

we are not doing enough to stamp out conflicts of interest within 

the credit rating agency sector of our economy or the financial services industry. We have a lot of work to do there. 

Mr. Butler, in response to Mr. Lynch’s questions, you indicated 

that in terms of full compliance with new regulations that are 

being issued by the SEC, that you see this more as—I think you 

said a journey rather than a destination. I would hope the destination is full compliance with all the new regulations, including 

stamping out all conflicts of interest. 

Maybe you can explain what you mean by a journey rather than 

a destination? I hope the journey is pretty quick and that we are 

not adrift in that journey. What did you mean by that, that it is 

more of a journey than a destination? 

Mr. BUTLER. What I meant by that, Congressman, is compliance 

isn’t an end state that companies achieve and then compliance is 

over. I view compliance as something that is needed every single 

day. 

The firms have large compliance staffs. They have been adding 

significantly to the numbers of their compliance staffs. They have 

been conducting reorganizations internally to effect enhanced compliance. 

And what I meant by saying it is a journey not a destination is 

that this is a continually evolving necessity. As the industry 

changes, as the types of products change, the types of compliance 

that is necessary within the firms may itself need to change. 

Mr. FITZPATRICK. Certainly, you are concerned about conflicts 

within especially the big three of the credit rating agencies, since 

those big three account for, what, 80 percent of the market? 

Mr. BUTLER. We have been very concerned about conflicts of interest across all the 10 registrants that are registered with the 

SEC— 

Mr. FITZPATRICK. I want to follow up on Mr. Sherman’s questions 

about this Peruvian issue. Certainly, you have seen the newspaper 

stories and the advertisements about the agrarian land bonds. Are 

you familiar with that? 

Mr. BUTLER. I am familiar with some of the media coverage 

about the bonds, yes, sir. 

Mr. FITZPATRICK. Can you explain to the committee what your 

understanding is of the conflict at this point? 

Mr. BUTLER. With regard to the Peruvian bonds, I really don’t 

have any particular details other than what the media reported, 

and it had to do with two of the rating agencies, one of which is 

registered with the SEC for sovereigns and one of which is not. 

Mr. FITZPATRICK. I am looking at a Standard & Poor’s rating 

services. This appears to be an analysis of the Republic of Peru 

done about 6 months ago, September 2015. It seems to have rated 

37 

as investment grade with a stable outlook—the sovereign debt or 

the bonds of the Republic of Peru. 

But you are aware that there are other bonds issued by the government a couple of decades ago that are in default? You have 

heard that, correct? 

Mr. BUTLER. I have seen the media articles on it. It has been a 

while since I read the media articles on it. 

Mr. FITZPATRICK. And you are aware that these same rating 

agencies are not willing to rate that debt for some reason? Are you 

aware of that? 

Mr. BUTLER. Again, it has been a while since I read the media 

coverage on it— 

Mr. FITZPATRICK. With respect to this particular issue, what are 

the circumstances that a rating agency should be permitted to rate 

new sovereign debt, get paid to do that—and that is part of their 

business model; I understand that—but ignore the requests of the 

investor community to rate other debt issued by the government 

that is in default? 

How is it the rating agencies get to pick and choose what debt 

they are going to rate and what debt they are not going to rate, 

especially when it affects small investors in the United States of 

America? 

Mr. BUTLER. The rating agencies are required to establish, maintain, and enforce policies and procedures to address their conflicts 

of interest. And within that, there are conflicts of interest identified 

which would be disclosure-based, and others that are absolutely 

prohibited. And prohibited conflicts would include the separation— 

Mr. FITZPATRICK. But what kind of discretion does a credit rating 

agency have to just decide on their own what they are going to rate 

and what they are not going to rate? 

Mr. BUTLER. With regard to our oversight, Congressman, we look 

at the work and the work product that has been done. We don’t 

have authority with regard to the substance of ratings or the procedure or methodology— 

Mr. FITZPATRICK. I’ll tell you what my concern is. My concern is 

that there are pension funds in half of the States in this country 

that have invested the retirements savings of police officers, of firefighters, of building construction trades workers, average everyday 

Americans who are losing money in certain investments where 

Standard & Poor’s, in this particular case, has said, ‘‘Yes, the Republic of Peru is investment-grade,’’ but they are in default on 

other bonds. 

And I am concerned that they are deciding what bonds they are 

going to rate and what bonds they are not going to rate, because 

if they rated these land bonds that were issued a couple of decades 

ago and found out that they are all in default, that would affect 

all of the other ratings that they have issued. And that may have 

an effect on the ratings not just of the Republic of Peru, but other 

corporate bonds that they have rated also within that governmental area. 

So I would ask you to take a look at that and question the rating 

agencies—four or five or however many there are, not very many; 

not enough, I would say—and question them as to how they are 

using the discretion what to rate, what not to rate, whether there 

38 

is a conflict inherent in that decision, and how many small investors, how many working-class Americans are being affected, negatively impacted, losing retirement savings as a result. Would you 

do that for me? 

Mr. BUTLER. Thank you, sir. 

Mr. FITZPATRICK. Would you do that? 

Mr. BUTLER. I am not at liberty to discuss the substance of an 

examination, but I am happy to take your comment under advisement. 

Mr. FITZPATRICK. I will follow it up with you. Thank you. 

Thank you, Mr. Chairman. 

Chairman GARRETT. Thanks. 

And before I call on the gentleman from Maine, I just want clarity as to one of the answers on that. 

When you say that there are already rules in place as far as the 

conflict of interests for what—the decision by the rating agency, I 

think I understand what you are saying. But the conflict that they 

have is on the—that conflict that they have to make sure that 

there isn’t a conflict of interest is on the—going forward, the decision—on the entity that they are going to be rating tomorrow. So 

if they are rating the XYZ country or entity over here, they have 

to make sure there is no conflict in that decision, right, is what you 

are saying? 

Mr. BUTLER. The new rules that were adopted in August 2014, 

effective June 2015, require—there is a certificate with regard to 

any rating action. The rating action could be either a new issuance 

or a surveillance of an old rating. 

Chairman GARRETT. Right. But it doesn’t really go to the point 

that the gentleman from Pennsylvania was making as far as their 

decision not to rate someone. There is no question, you don’t look 

to see whether there was a conflict of interest when they decided, 

‘‘We are not going to rate X, Y, and Z.’’ Is that correct? 

Mr. BUTLER. As it is currently crafted today, we are looking for 

surveillance activities and new issuance activities. 

Chairman GARRETT. Okay. Thank you. 

With that, last, but certainly not least, the gentleman from 

Maine is recognized for 5 minutes. 

Mr. POLIQUIN. Thank you, Mr. Chairman. I appreciate it very 

much. 

Mr. Wyatt, you represent or you are the Director of the Office of 

Compliance, Inspections, and Examinations for the SEC, correct, 

sir? 

Mr. WYATT. That is correct. 

Mr. POLIQUIN. Okay. And the SEC has about 4,000 employees 

and a budget of about $1.6 billion the last time I looked? 

Mr. WYATT. SEC-wide, that is correct. 

Mr. POLIQUIN. Yes, exactly. And of those 4,000 employees, 1,000 

work for you. 

Mr. WYATT. 1,011, yes, sir. 

Mr. POLIQUIN. Okay. 

I represent Maine’s 2nd District. This is western, central, northern, and down east Maine. It is the most wonderful part of the 

world. If you haven’t vacationed there, Mr. Wyatt, I know you are 

going to want to take your other associates with you to go vacation 

39 

there this summer, which is upon us. We have a little bit of snow 

in Aroostook County, but it is melting. 

Now, we are a district of small business owners. We are a district 

of small savers—hardworking people; honest people; people putting 

aside $50, maybe $100 a month to save for their kid’s college education or maybe for their retirement. 

Now, your job at the SEC—and all your jobs—is to make sure 

that there is integrity with respect to our publicly traded and other 

securities to make sure our investors have a fair shake at knowing 

what they are investing in. 

Now, help me out, if you don’t mind, Mr. Wyatt. Your budget 

goes up for the entire—not just yours, but your part of it—for the 

SEC you always come back to us every year for more money. And 

I think you asked for another 10 or 15 percent from last year to 

this year. 

So my question is, with 1,000 folks on your staff, how many examinations per inspector do you folks conduct for our registered investment advisers, the folks who manage our pension funds and 

our 401K funds and IRAs? How many examinations per inspector 

per year? 

Mr. WYATT. The average is six to nine per examiner. So I would 

highlight that we do not conduct examinations on an individual 

basis; our examiners go out and examine investment advisers in 

teams. 

Mr. POLIQUIN. Right. Okay. 

Six to nine, okay. But you ask for an increase in your budget 

every year. What was the number—how many examinations did 

your teams conduct the year before? 

Mr. WYATT. Last year, we conducted 1,992— 

Mr. POLIQUIN. No, how many per inspector, Mr. Wyatt? 

Mr. WYATT. Per inspector it was—we have had a 23 percent increase in the number of exams per examiner in the past 3 years. 

Mr. POLIQUIN. Okay. Thank you. I appreciate that very much. 

Let’s continue to drill down a little bit on these examinations, sir. 

I know that the Administration’s financial regulations ask you to 

make sure that you conduct robust examinations of the investment 

advisery space. And if I am not mistaken, there are about 14,000 

registered investment advisers in America. Did I get that right? 

Mr. WYATT. Roughly 12,000, yes, sir. 

Mr. POLIQUIN. Roughly. Okay. 

Do you think that you folks have spent a disproportionate 

amount of time recently on the private equity space—in other 

words, the type of investment adviser that deals with more accredited investors, larger investors, more sophisticated investors, as 

compared to folks who don’t make a living investing but might be 

nurses or teachers or folks who work in the forest products industry in our districts? 

Do you spend a disproportionate amount of your time, sir, on the 

private equity examinations for large investors, as compared to the 

investment adviser space for smaller investors? 

Mr. WYATT. I would suggest that those large investors that you 

are referring to are the endowments institutional investors and 

pension funds. Those pension funds are investing on behalf of the 

firefighters, the police officers, and the teachers. 

40 

Mr. POLIQUIN. Yes. 

Mr. WYATT. I would say with regards to our examinations of private funds, we have been very efficient in the resources we have 

dedicated to them. When they came into registration with the SEC 

as a result of Dodd-Frank, we conducted the presence exam initiative, when we had focused, limited-scope examinations of private 

funds. Those funds uncovered some activities regarding fees and 

expenses and allocation of trades that resulted in funds being returned to those institutional investors who, again, are investing on 

behalf of the firefighters— 

Mr. POLIQUIN. Sure. 

Mr. WYATT. —policemen, and teachers. 

Mr. POLIQUIN. But I think you would—and I appreciate that you 

want to make sure that your scope of examination expands all investment types, and I understand that. 

Mr. Wyatt, wouldn’t you agree that it is incumbent upon us to 

make sure we look out for the small saver, the small investor, 

whereas those who make a living in that business are usually better able to get the information they need to make their investments? 

Mr. WYATT. We certainly want to protect investors. We certainly 

are doing our utmost to increase our exam coverage. 

I would highlight to you, as a result of our examinations of the 

private fund, many of those institutional investors have come to 

OCIE and asked for our assistance in how they can improve their 

due diligence because we got access to information that they otherwise wouldn’t get in the course of their due diligence. 

So we are sharing that information so those institutional investors can be more informed when they make investments, and we 

are also doing our utmost to expand our coverage ratio within the 

investment adviser space to get to roughly 10 percent a year, 

roughly 30 percent of the assets under management. 

We hit a 4-year high with regards to the number of examinations 

we have done, but in a 2-year period we have had a net increase 

of advisers of roughly 1,000. So we are continuing to increase our 

numbers. 

We certainly want to dedicate resources to improve our efficiencies. We certainly want to make sure we are doing our utmost 

to protect investors. 

Mr. POLIQUIN. Thank you, Mr. Wyatt. 

Mr. Chairman, if I may just continue one line of questions, 

please, sir? I am the last one here. 

Chairman GARRETT. You have more questions? 

Mr. POLIQUIN. Yes, sir. I do. 

Chairman GARRETT. Go ahead. 

Mr. POLIQUIN. Thank you very much. Thank you, Mr. Chairman. 

And thank you, Mr. Wyatt. Mr. Wyatt, what would be a great 

help to me and my office in representing our 2nd District of Maine, 

and also, I am sure, to our committee and the rest of the country, 

is when you are dealing with such an important part of our capital 

markets, you must have in your department a written set of procedures such that we, who are responsible for oversight for your entity, can make sure that we know exactly how you are conducting 

your business, exactly how you make your decision on what inspecVerDate Nov 24 2008 15:26 Aug 14, 2017 Jkt 024068 PO 00000 Frm 00046 Fmt 6633 Sfmt 6633 K:\DOCS\24068.TXT TERI
41 

tors go where and what the expectation is for the number of examinations, just to make sure when you folks come back to us and ask 

for more money, we know that the taxpayers are getting the right 

bang for the buck. Would you be able to provide those procedural 

guidelines to us? 

Mr. WYATT. We are doing our utmost to be as transparent as possible about— 

Mr. POLIQUIN. Do you have a set of written guidelines, sir, that 

we— 

Mr. WYATT. We have a guideline—we have an exam manual that 

we use that is private. 

Mr. POLIQUIN. Yes, but that is for the examinations. I am talking 

about for Congress, that represents the people. Do you have a set 

of procedures that articulate exactly how you conduct your examinations? 

Mr. WYATT. That is our exam manual that guides how we conduct our examinations, yes— 

Mr. POLIQUIN. Okay. And can you add an addendum to that such 

that we know what kind of activity—the amount of activity for the 

money that we are spending on behalf of your organization such 

that taxpayers know that they are getting their money’s worth? 

Mr. WYATT. We can certainly liaise with your office to try to provide you with the information that you are seeking. 

Mr. POLIQUIN. That would be great. And we will be in touch with 

you—what is today? Today is Thursday? We will be in touch with 

you tomorrow. 

Mr. WYATT. I look forward to it. Thank you. 

Mr. POLIQUIN. Thank you, Mr. Wyatt. I appreciate it. 

And thank you very much, Mr. Chairman. 

Chairman GARRETT. Thank you. 

Since no one else is here, I could just go on for hours here, but 

I won’t. I will just ask two quick questions, just to drill back down 

a little bit on something else. 

I think Vice Chairman Hurt raised this question, Mr. Flannery, 

as far as taking a look back at—doing a look back at past rules and 

how that is all supposed to work and what have you, can you just 

spend 30 seconds? What is your game plan, what is your goal, to 

look backwards towards the last half a dozen years of rules that 

have been promulgated over the last half a dozen years and just 

see whether they are all working? 

Mr. FLANNERY. Of course, one of the biggest sources of rules over 

the past half dozen years has come out of the Dodd-Frank Act. 

Chairman GARRETT. Right. 

Mr. FLANNERY. And I know that the Congress is concerned about 

the cumulative effect of the Dodd-Frank rules and regulations on 

liquidity in financial markets. So DERA has been charged with 

doing a study on that very thing. 

I think it is a terrific study to be doing. We have started. We 

haven’t gotten deeply into it. 

But the question of how liquid are our financial markets, particularly maybe the debt markets, I think has very important policy 

implications both here and around the world, and so we are looking 

forward to doing that. 

42 

And the impact of these cumulative regulations on that liquidity 

is going to be an important conclusion. An assessment of that is 

going to be an important conclusion of our study. 

Chairman GARRETT. Okay. And, of course, that always begs the 

question as to when? 

Mr. FLANNERY. You have told us, which is that we will get back 

to you within a year of the omnibus act last year being passed. I 

think that is our first draft, and 18 months is the final draft. 

Chairman GARRETT. And that will look into also, besides those 

two points, will look into the—I will say the cost, economic impact 

on the industry and the marketplace? 

Mr. FLANNERY. On the liquidity, as I understand it, is what you 

are primarily interested in. 

Chairman GARRETT. Well, yes. That I get. It will look at the liquidity. 

But will it also look at the overall cost? What is the economic 

cost measured in dollars and cents to the industry, per se? It is 

costing us—this firm X millions of dollars to do it and this firm X 

millions of dollars, what the total cost—that may or may not impact always upon liquidity I presume, right? It costs another $10 

million to do so, but liquidity stays the same. 

Mr. FLANNERY. Right. 

Chairman GARRETT. So you are doing liquidity over here. That 

is good. Are you also looking out to the overall nominal cost, I 

guess is the word? 

Mr. FLANNERY. Yes. I think the nominal cost would be the word. 

And that would certainly be a part of that study. A part of any economic analysis is to set a baseline, and the baseline would include 

considerations of the costs of operating today, absolutely. 

Chairman GARRETT. Yes. And I will end here where you began, 

with one of my very first questions. 

I have heard some good things as far as what you are talking 

about here from industry and otherwise, as far as in your—one of 

your opening comments, and it was talking about how this—some 

of this information is now being put out, as far as your studies and 

what you have presented. 

I will put it this way: Is that as far as you can go, or can you 

improve that? Can you reveal—I don’t know what the right word 

is here—more information as far as the methodology, the data 

points, and everything else that goes into it? And I ask that question because some folks look here and say, ‘‘Good,’’ but look at other 

agencies and how they do their analysis that you do in their area 

and they put out a fuller, more complete, more in-depth background, if you will, onto that. 

Do you see a comparison—maybe I should put it that way—do 

you see a comparison to other ones at how—what you do, and do 

you see that you could do a little bit more or more in these areas? 

Mr. FLANNERY. Yes. I have been— 

Chairman GARRETT. That is my last question to you. 

Mr. FLANNERY. One of the things I have been working on in the 

past year-and-a-half since I got there— 

Chairman GARRETT. Yes. 

Mr. FLANNERY. —is the idea that we bring in all this registrant 

information, it is treated as confidential and private because the 

43 

registrants don’t wish to be identified for obvious reasons, but that 

shouldn’t interfere with our ability to provide information about 

various aggregated forms of that information. 

Chairman GARRETT. Okay. 

Mr. FLANNERY. If we are going to be useful, we have to tell people how we made the decision about the aggregation, so I agree 

with you entirely about that. 

Chairman GARRETT. Okay. And so you are going to be working 

on— 

Mr. FLANNERY. Yes. 

Chairman GARRETT. Okay. 

Mr. FLANNERY. Yes. 

Chairman GARRETT. That is good. 

So with that all being said, I thank the members of the panel 

and all the witnesses here today. 

The Chair notes that some Members may have additional questions for this panel, which they may wish to submit in writing. 

Without objection, the hearing record will remain open for 5 legislative days for Members to submit written questions to these witnesses and to place their responses in the record. Also, without objection, Members will have 5 legislative days to submit extraneous 

materials to the Chair for inclusion in the record. 

And I would be remiss if I did not add this, that if you can’t 

make the trip all the way up to Maine, the snow is already gone 

in New Jersey and things are blooming already in New Jersey. It 

will be another 6 months before the snow and the ice melts in 

Maine. 

So with that, this hearing is adjourned. 

[Whereupon, at 11:44 a.m., the hearing was adjourned.] 

(45) 

A P P E N D I X 

April 21, 2016 

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Testimony on Continued Oversight of the SEC's Offices and Divisions 

Before The U.S. House of Representatives Committee on Financial Services 

Subcommittee on Capital Markets and Government Sponsored Enterprises 

Washington, D.C. 

April 21, 2016 

Chainnan Garrett, Ranking Member Maloney, and Members of the Subcommittee: 

Thank you for your invitation to testify on behalf of the U.S. Securities and Exchange 

Commission (SEC or Commission) about the responsibilities and recent activities of the Division 

of Economic and Risk Analysis (DERA), the Office of Compliance Inspections and 

Examinations (OCJE), the Office of Credit Ratings (OCR), and the Office of the Whistleblower 

(OWB). 

In recent years, the SEC has made substantial progress in strengthening its operations and 

programs. The agency has proposed or adopted nearly all of the mandatory rulemakings required 

by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) and the 

Jumpstart Our Business Startups Act (JOBS Act), in addition to advancing other key rules in 

mission critical areas that protect investors and our markets. In addition to implementing 

congressionally mandated rules, the SEC has also advanced other important policy objectives, 

including rules to enhance oversight of high-frequency traders and the agency's supervision of 

investment advisers and mutual funds. including refonns to money market mutual funds; as well 

as adopting requirements for comprehensive new controls at critical market participants to 

strengthen key technological systems. 

Beyond the rulemakings, the SEC has intensified its review of equity and fixed income 

market structure issues, undertaken a disclosure effectiveness initiative seeking ways to improve 

the pub lie company disclosure regime for investors and companies, and continued to act 

aggressively to hold securities law violators accountable. Broad, systemic enhancements in the 

SEC's National Examination Program (NEP)- including increased recruitment of industry 

experts, the augmentation of data analytics capacities, and enhanced training programs- have 

led to a more effective, efficient program. The agency also is increasingly harnessing technology 

to better identify risks, uncover frauds, sift through large volumes of data, inform policymaking, 

and streamline operations, while at the same time improving internal collaboration and recruiting 

more statfwith specialized expertise and experience. While these and other critical 

improvements have been made, challenges remain in the Commission's efforts to address the 

growing size and complexities of the securities markets and fulfill the SEC's broad mandates and 

responsibilities. Our testimony will discuss the role each of our divisions and offices play in 

fulfilling the important mission of the Commission, developments in our respective areas, and 

some of our recent work. 
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To continue and expand on our efforts, as set forth in the SEC's FY 2017 budget request, 

the SEC is requesting $1.781 billion in support of 5,196 positions and 4,870 full time equivalents 

(FTE). 1 This requested budget level is essential to support the agency's mission to protect 

investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. 

Specifically, as described in more detail below and consistent with the planning reflected in our 

recent requests, the budget for FY 2017 seeks to: 

Increase examination coverage of investment advisers and other key entities who 

interact with retail and institutional investors; 

Further leverage cutting-edge technology to permit the SEC to better keep pace 

with the entities, markets, and products we regulate; 

Protect investors by enhancing our enforcement program's investigative 

capabilities and strengthen our ability to litigate against wrongdoers; 

Further bolster the SEC's economic and risk analysis functions; and 

Hire market and other experts to enable the SEC to more expertly and efficiently 

discharge its current rulemaking and oversight responsibilities. 

As you are aware, the SEC's funding is deficit-neutral, which means that any amount 

appropriated to the agency will be offset by modest transaction fees (approximately $.02 per 

$1,000) and therefore will not impact the deficit or the funding available for other agencies. Our 

appropriation also does not count against the FY 2016 or FY 2017 caps set in the Bipartisan 

Budget Act of2015. 

DIVISION OF ECONOMIC AND RISK ANALYSIS 

Director and Chief Economist, Mark J. Flannery 

The Division of Economic and Risk Analysis supports the Commission's mission through 

data-driven, high-quality economic analyses. Over the past several years, DERA has grown from 

approximately 96 employees in 2013 to a projected workforce of 175 by the end of2016. By 

that time, DERA anticipates employing 88 Ph.D.s mostly in economics or finance, but also 

accountants and two physicists. This set of social scientists is supported by 22 research 

associates. DERA staff also includes a diverse team of other technical experts and professional 

staff. The Division's rapid growth and resultant depth of expertise has allowed DERA to expand 

its support across an ever-increasing range of Commission activities. 

1 A copy of the SEC's FY 2017 Congressional Budget Justification is available at 

http://www .sec. gov I about/reports/secfy 1 7 congbudgjust shtm I 

2 
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Rulemaking and Policy Support 

DERA's most well-known function is to provide economic analyses in support of 

Commission rulemaking and other priority initiatives. DERA economists examine the need for 

regulatory action, analyze the potential economic effects of proposed and final rules, and 

evaluate public comments. DERA provides theoretical and data-driven economic analyses of 

potential new policies and changes to existing policies, working closely with staff from other 

Commission divisions and offices from the earliest stages of policy development through the 

finalization of a particular rule. DERA staff also provides analysis, where appropriate, to support 

the Commission's consideration of self-regulatory organization (SRO), Municipal Securities 

Rulemaking Board (MSRB), and Public Company Accounting Oversight Board (PCAOB) rules. 

In the course of assisting other divisions and offices, staff routinely prepares white papers 

and other documents that present novel economic analyses of specific policy issues or 

rulemakings. For example, last year DERA staff published two white papers in conjunction with 

two of the Division oflnvestment Management's recent rulemakings- one related to liquidity 

requirements for open-end mutual funds, and another about funds' derivatives usage. Stat!' also 

produced a white paper on voluntary clearing activity in the single-name credit default swap 

market and a white paper analyzing the market for unregistered securities offerings. 

Risk Assessment 

DERA also provides financial and risk modeling expertise to other divisions and offices 

in support of their supervisory, surveillance, and investigative programs related to corporate 

issuers, broker-dealers, investment companies, and exchanges and trading platforms. Our data 

analysis helps SEC staff with examination prioritization and scoping, including providing 

guidance on which entities to examine, and what to look for during the examinations. 

DERA recently developed a "Broker-Dealer Risk Assessment" tool in close collaboration 

with OCIE staff that analyzes how a firm's behavior compares to its peers to identify anomalous 

behavior that might indicate risks in a broker-dealer's operations, financing, workforce, or 

structure. The tool also provides predictors of potential misconduct based on risk factors 

developed using OCIE's historical exam findings. These results help OCIE to prioritize 

inspections, as well as to focus examiners' attention during an inspection to increase the 

likelihood of detecting misconduct. 

Another recent project the Corporate Issuer Risk Assessment tool (CIRA) helps 

expert staff to assess corporate issuer risk by identifying financial reporting irregularities that 

may indicate financial fraud. Developed in coordination with the Division of Enforcement, 

CIRA produces over 200 custom metrics that the stat!' can usc in analyzing issuer behavior and in 

identifying companies that may warrant further inquiry. 

Litigation Economics 

DERA staff also support the Division of Enforcement by applying economic theory and 

statistical methods to answer key questions that arise during investigations, settlement 

3 
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negotiations, and litigation. In fiscal year 2015, DERA staff provided expert assistance in over 

120 new enforcement matters, including accounting fraud, insider trading, and market 

manipulation cases. DERA staff assists Enforcement statT in identifying securities law 

violations, quantifying the harm to investors, and calculating ill-gotten gains. DERA staff also 

evaluate economic-based claims of the defendant- for example, that a penalty would cause a 

company undue harm. For cases that go to trial, DERA staff work with Enforcement's Trial Unit 

to help prepare the Commission's outside experts and to challenge the work of opposing experts. 

In certain cases, DERA staff have testified on behalf of the Commission. 

Data Oversight 

Along with performing complex data analytics, DERA acts as a central hub for the intake, 

processing, and use of data within the Commission. DERA's data oversight activities fall into 

two distinct, but related, categories. 

First, DERA works closely with other SEC divisions and offices to design data 

structuring approaches for required disclosures, and supports the SEC's data collections and data 

usage by designing taxonomies, validation rules, data quality assessments, and data 

dissemination tools to facilitate high-quality data analyses. DERA also works with investors, 

regulated entities, and the public to support the submission and use of structured data. 

Second, DERA is responsible for the day-to-day management of many Commission 

databases. DERA staff routinely generates summary information and statistics about key aspects 

of the financial markets, and provide Commission staff with direct access to the underlying data. 

DERA also develops and refines financial market datasets gathered from sources both internal 

and external to the Commission. 

Research 

DERA encourages its staff to be active participants in the academic community, 

particularly as it investigates and debates topics relevant to the SEC's mission. Staff regularly 

have their research papers published in refereed publications that cover finance, economics, and 

accounting, and staff papers are posted on the DERA webpage of the SEC website to ensure the 

public can access current research on the financial markets. 

OFFICE OF COMPLIANCE INSPECTIONS AND EXAMINATIONS 

Director, Marc Wyatt 

OCIE, through its National Examination Program, protects investors, ensures market 

integrity, and supports responsible capital formation through risk-focused strategies that: (1) 

improve compliance; (2) prevent fraud; (3) monitor risk; and (4) inform policy. The results of 

OClE's examinations are used by the Commission to inform rule-making initiatives, identify and 

monitor risks, improve industry practices, and identify misconduct. 

With a staff of over I ,000 employees, OCIE has examination responsibility for registered 

entities consisting of more than 12,000 investment advisers, 11,000 mutual funds and exchange4 
50 


24068.005

traded funds, over 4,000 broker-dealers, more than 400 transfer agents and more than 650 

registered municipal advisors. OCIE also has oversight responsibility for 18 national securities 

exchanges, the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking 

Board, the Securities Investor Protection Corporation (SIPC), six active registered clearing 

agencies, and the PCAOB. Recent legislative changes by the Dodd-Frank Act and the JOBS Act 

have expanded OCIE's responsibilities to include examinations of, among others, security-based 

swap dealers, security-based swap data repositories, major security-based swap participants, 

securities-based swap execution facilities and crowdfunding portals. Compounding the 

challenges in the sheer number of registrants is the continued growth in the financial markets and 

complexity of its participants. For example, over the past fifteen years, assets under 

management of SEC-registered advisers grew by approximately 210 percent to approximately 

$66.8 trillion, and assets under management of mutual funds grew by almost 125 percent to over 

$15 trillion today. In order to maximize the use of our limited staff, OCIE is in the formative 

stages of reallocating examiners across its program to increase coverage of investment advisers. 

In fiscal year 2015, examiners in II regional offices and headquarters conducted nearly 

2,000 examinations, including: 484 examinations ofbrokcr-dcalers; 1,221 examinations of 

investment advisers; 137 examinations of investment company complexes; 53 examinations of 

transfer agents; 6 examinations of clearing agencies; and 50 examinations of municipal advisors. 

The staff also conducted 21 SRO program examinations and 20 Technology Controls Program 

examinations, which are inspections of the regulatory operations and automated trading and 

clearing processes of markets and clearing organizations. Approximately 77 percent of all fiscal 

year 20 I 5 examinations identified deficiencies and approximately I I percent resulted in referrals 

to the Division of Enforcement. 

To meet the challenges posed by a registrant population that far exceeds OCIE resources, 

OCIE has adopted a risk-based approach to examinations, utilized data analytics, and promoted 

compliance through transparency. 

Risk-Based Approach 

OCfE has adopted a risk-based examination approach with respect to the firms selected 

for examination, the areas of the firm examined, and the issues covered. OCIE's Office of Risk 

Assessment and Surveillance (RAS) aggregates and analyzes data 1rom SEC filings from 

registrants and individuals to identify activity that may warrant examination. In fiscal year 2015, 

RAS significantly expanded its data analysis and monitoring efforts to incorporate data from 

sources internal and external to the Commission, including, for example, data collected by or 

filed with other regulators, SROs, and exchanges, as well as information that registrants provide 

to data aggregators regarding, for example, their business activities and marketing-related efforts. 

This expanded data collection and analysis enhances OCIE's ability to identify operational red 

flags throughout entire industries such as firms with aberrant swings in reported assets under 

management, changes in key individuals, business activities, and affiliates, migration of bad 

actor industry participants and other possible indicia of heightened risk and enables examiners 

to develop a better understanding of firms prior to launching an examination. 

5 
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24068.006

Data-Driven 

Over the past five years, OCIE has recruited experts to enhance OCIE's technology and 

its use of data analytics to improve its risk-based examination approach. For example, last fiscal 

year, OCIE's Quantitative Analytics Unit (QAU) improved the National Exam Analytics Tool, 

which enables examiners to access and systematically analyze years' worth of a registrant's 

trading data much faster than ever before. QAU has also been developing technologies to help 

examiners detect suspicious activity in areas such as money laundering and high frequency 

trading that will further expand and enhance OCIE's capabilities to fight and deter fraud. 

OCIE's Risk Analysis Examination (RAE) Team also uses technology to conduct 

examinations of some of the nation's largest broker-dealers. By analyzing transactions cleared 

by firms over several years, RAE has identified possible problematic behavior across multiple 

firms, including unsuitable recommendations. misrepresentations, inadequate supervision, 

chuming. reverse chuming, and load waivers. 

Enhanced Transparency 

OCIE improves industry compliance with the Federal securities laws and promotes better 

industry risk management practices through examinations and greater transparency. OCIE 

engages in extensive communication and outreach initiatives with the industry and other 

regulators. By communicating with registrants through outreach and published material, OCIE 

provides registrants with tools to self-assess and remediate any non-compliant behavior on their 

own. For example, each year, OCTE publishes its annual public statement of examination 

priorities to inform investors and registrants about areas that the statT believes present heightened 

risk and to support the SEC's mission. 2 

In addition, OCIE conducted 129 outreach and educational program events in fiscal year 

2015. including Compliance Outreach seminars, targeted sessions with never-before-examined 

advisers, and other outreach initiatives with registrants, regulators, and industry groups. As part 

of this effort, OCIE also issued six Risk Alerts (among other significant published materials) on 

such topics as investment advisers and funds that outsource their chief compliance officer 

function, broker-dealer controls regarding retail sales of structured securities products, and 

never-before-examined registered investment companies. 

2 See https://www.sec.gov/aboutloffices/ocie/national-examination-program-priorities-2016.pdf. 

6 
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24068.007

Select Priority Initiatives 

Currently, OCIE is pursuing several key initiatives that are critical to the protection of investors. 

ReTIRE Initiative 

In June 2015, OCIE launched a multi-year examination initiative (ReTIRE), focusing on 

SEC-registered investment advisers and broker-dealers and the services they offer to investors 

with retirement accounts. 3 OClE is focusing on retirement-based savings because retail 

investors arc faced with a complex and evolving set of factors when making critical investment 

decisions. Some of these factors include the broad and changing array of investments available, 

the variety of services offered, the changing market environment. and commissions and sales 

charges associated with these investments. OCIE has and will continue to focus its examinations 

on certain higher-risk areas of registrants' sales, investment, and oversight processes, with 

particular emphasis on select areas where retail investors saving for retirement may be harmed, 

including: the reasonable basis for recommendations; conflicts of interest; supervision and 

compliance controls; and marketing and disclosure. As ofMarch 10,2016, OCIE had initiated 

approximately 200 examinations pursuant to this initiative, which will continue to he a priority in 

2016. 

Cybersecurity 

In the last two years, OCIE has conducted examinations to identify cybersecurity risks 

and assess cybersecurity preparedness among broker-dealers and investment advisers. 4 These 

examinations focus on: governance and supervision of information technology systems; 

operational capability; information security; preparedness for cyber-attacks; access rights and 

controls; data loss prevention; vendor management; training; and incident response. OCIE made 

public a summary of its observations and findings. Notable among these was the observation 

that the vast majority of examined tirms conduct periodic risk assessments, on a firm-wide basis, 

to identify cybersecurity threats, vulnerabilities, and potential business consequences, but fewer 

finns conduct a similar analysis of vendors. 5 In 2016, OCIE is continuing this effort, including 

3 See OCJE Risk Alert, "Retirement-Targeted Industry Reviews and Examinations Initiative," June 22, 2015, 

.b.!:ill://www.sec.gov/about/offices/ocie/retirement~targeted~industry·reviews-and-examinations-initiative.pdf. 

4 See OCIE Risk Alert, "OCIE's 2015 Cybersecurity Examinations Initiative," Sept. 15, 2015, 

https://www.sec.gov/ocie/announccmentlocie-20 15-cybersecurity-examination-initiative.pdt; OCIE Risk Alert, 

"OCIE Cybersecurity Initiative," Apr. 15, 2014. ]1ttp://www.scc.J6QY/ocie/announcement!Cybersecurity-R,isk-Aiert--

Appendix---4.l.iJ.'!&Qf. 

5 See OCIE Risk Alert, "Cybersecurity Examination Sweep Summary," Feb. 3, 2015, 

https://www.sec.gov/about/offices/ocic/cybersecurity-examination-sweep-summary.pdf. 

7 
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24068.008

testing and assessments offinns' implementation of procedures and controls. As ofMareh 11, 

2016, OCIE had initiated over 160 examinations pursuant to this initiative. 

Liquidity Controls 

Amidst the changes in fixed income markets over the past several years, OCIE is 

examining advisers to mutual funds, ETFs, and private funds that have exposure to potentially 

illiquid fixed income securities. OCIE will also examine registered broker-dealers that have 

become new or expanding liquidity providers in the marketplace. These examinations include a 

review of various controls in these finns' expanded business areas, such as controls over market 

risk management, valuation, liquidity management, trading activity, and regulatory capital. As 

of March 11,2016, OCIE had initiated 193 such examinations. This priority builds on a 2015 

priority related to fixed income investment companies. 

OFFICE OF CREDIT RATINGS 

Director, Thomas .1. Butler 

With the enactment of the Credit Rating Agency Reform Act of2006 (CRA Reform Act), 

Congress provided the Commission with express authority to implement a registration and 

oversight program for credit rating agencies that elect to be treated as ''nationally recognized 

statistical rating organizations (NRSROs )." As mandated by the Dodd-Frank Act. the Office of 

Credit Ratings (OCR or the Office) was established at the Commission in June 2012. 6 

OCR is charged with administering the rules of the Commission with respect to the 

business practices of NRSROs. OCR monitors the activities and conducts examinations of 

NRSROs to assess and promote compliance with statutory and Commission requirements. OCR 

collaborates and coordinates with other Commission offices and divisions as warranted to 

enhance its ability to serve the public interest and protect users of credit ratings. 

Pursuant to the Dodd-Frank Act, OCR staff includes persons with knowledge of and 

expertise in corporate, municipal and structured debt finance. OCR is currently comprised of 

approximately 50 staff members located in New York and Washington, D.C. OCR's activities 

fall within the following areas: Examinations; NRSRO Monitoring and Constituent Monitoring; 

and Policy and Rulemaking, each of which is briefly described below. 

6 Prior to the establishment of OCR, examinations of the NRSROs were conducted by the Office of Compliance 

Inspections and Examinations, and NRSRO monitoring was undertaken by the Division of Trading and Markets. 

8 
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24068.009

Examinations 

Examinations ofNRSROs for compliance with federal securities laws and Commission 

rules account for the majority of OCR's activity. The Dodd-Frank Act requires that OCR 

conduct an examination of each NRSRO at least annually. 

The scope of the annual examinations covers eight review areas prescribed by the DoddFrank Act. Further, OCR employs a risk-based approach to exam planning, identifying different 

risks for different NRSROs. This improves the efficiency and the effectiveness of the NRSRO 

examinations, as resources are prioritized and focused on areas of higher risk. The examinations 

of the NRSROs may include a quantitative analyst to provide analytical support directly 

alongside the examination teams. In addition to the annual examinations, OCR conducts sweeps 

and targeted examinations to: (I) address credit market issues and concerns; and (2) follow up on 

tips, complaints, and NRSRO self-reported incidents. 

In conducting an NRSRO examination, OCR staff reviews, among other things: (I) the 

implementation of policies and procedures to assess compliance with the rules; (2) selected 

ratings files in connection with ratings issuances and surveillance activities; (3) internal controls 

and governance activities; and (4) internal compliance reports. As part of the examination, OCR 

examiners travel onsite to an NRSRO and conduct interviews of management and staff, 

including credit rating analysts, as well as members of the NRSRO's board of directors. 

To date, the NRSROs have been generally responsive to the Commission staff's findings 

and recommendations. Many have implemented fundamental changes, such as: increasing 

surveillance activities; strengthening policies and procedures for managing conflicts of interest; 

adding compliance staff and restructuring oversight functions within the organization; investing 

in multi-year technology initiatives; and enhancing disclosure, transparency and governance. 

The annual examinations that are currently underway include a comprehensive review of 

NRSROs' compliance with the significant new rules and rule amendments that were adopted by 

the Commission in August 2014, most of which became effective in June 2015. 

As required by the Dodd-Frank Act, OCR prepares an annual public examination report 

summarizing: (l) the essential findings of the examinations; (2) responses by the NRSROs to any 

material regulatory deficiencies identified by the Commission; and (3) whether the NRSROs have 

appropriately addressed previous examination recommendations. In December 2015, OCR 

published the fifth annual public examination report 7 

7 http://www.sec.gov/ocr 

9 
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24068.010

One important area complementing OCR's examinations is the potential for referral to 

the Commission's Division of Enforcement of any of the staffs findings. Past examinations 

have, in certain instances, led to enforcement referrals. 

NRSRO Monitoring and Constituent Monitoring 

The NRSRO Monitoring and Constituent Monitoring groups gather, analyze and assess 

data and identify trends across the industry. This infonnation provides useful input for 

examination scoping, determining and communicating best practices for NRSROs and guiding 

the direction for any future rulemakings related to NRSROs. Both groups also work 

collaboratively with, and serve as a resource to, other divisions and offices throughout the 

Commission. 

NRSRO Monitoring conducts periodic meetings with NRSROs separate from the 

examination function, and may also meet on an ad hoc basis at an NRSRO's request or 

proactively as necessary to respond to NRSRO or industry developments. The group meets with 

certain NRSRO boards of directors (including a separate discussion with the independent 

directors), in addition to the meetings with the directors that the OCR examiners conduct, in an 

effort to engage the directors in broader policy discussions. NRSRO Monitoring is also 

responsible tor reviewing the annual and periodic registrant updates submitted on Form NRSRO, 

reviewing the NRSRO Employment Transition Reports for former employees ofNRSROs, and 

receiving tips from NRSROs that are reported pursuant to Section 15E(u) of the Securities 

Exchange Act. 

Constituent Monitoring holds meetings with investors, issuers, arrangers, and industry 

trade groups. The group conducts ad hoc research as warranted by industry or credit market 

conditions. The group also discusses matters of common interest with other U.S. government 

agencies. Constituent Monitoring analyzes the differences in types of investors that affect their 

reliance on credit ratings and their views ofNRSROs, the profiles of investor organizations and 

regulatory issues faced by other industries (e.g.. investment banking, commercial banking, and 

accounting) that arc akin to NRSRO issues, and how other industries may have addressed similar 

issues. 

Policy and Rnlemaking 

The Policy and Rulcmaking group is responsible for developing rule recommendations 

for the Commission's consideration. The group also reviews requests for Commission 

exemptive relief or staff"no-action" relief from existing rule requirements. The group is 

instrumental in formulating staff guidance and other interpretive positions for OCR. The group 

receives feedback from the NRSRO examinations and from OCR's monitoring activities to help 

inform its policy recommendations. The Policy and Rulemaking group also reviews initial 

applications for NRSRO registration and applications from existing NRSROs for registration in 

additional ratings classes. 

10 
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24068.011

Pursuant to the CRA Reform Act, the Commission adopted rules establishing a 

regulatory oversight program for NRSROs and thereafter adopted amendments to several of 

those rules. The Commission's rules established a registration program for NRSROs and 

imposed disclosure, recordkeeping and reporting requirements. The Commission has broad 

authority to: (!)examine all books and records of an NRSRO; and (2) impose sanctions for 

violating statutory provisions and the Commission's rules. However, the Commission is not 

permitted to regulate the substance of credit ratings or the procedures and methodologies used to 

determine credit ratings. 

As required by the Dodd-Frank Act, the Commission adopted a comprehensive set of 

new rules and rule amendments to strengthen the integrity and improve the transparency of credit 

ratings. 8 The rules address, among other things: reporting on internal controls; conflicts of 

interest with respect to sales and marketing practices, including the requirement to separate sales 

and marketing activities from analytics; disclosure of credit rating performance statistics; 

procedures to protect the integrity and transparency of rating methodologies, including the 

requirement tor the NRSRO's board of directors to approve a methodology before it is used; 

disclosures to promote the transparency of credit ratings; and standards for training, experience 

and competence of credit analysts. The requirements provide for an annual certification by the 

CEO as to the effectiveness of internal controls and additional certifications to accompany credit 

ratings attesting that no part of the credit rating was influenced by any other business activities. 

The Policy and Rulemaking group in OCR is responsible for conducting studies and 

drafting reports, including those required under the CRA Reform Act and the Dodd-Frank Act. 

In December 2015, OCR published the eighth Annual Report on NRSROs, as required under the 

CRA Reform Act. 9 The report provides a snapshot of the industry, including stafTviews on 

competition, transparency and conflicts of interest. 

OFFICE OF THE WHISTLEBLOWER 

Chief, Scan McKessy 

Pursuant to the Dodd-Frank Act, the Commission established the Office of the 

Whistleblower (OWB), a separate office within the Division of Enforcement, to administer the 

whistleblowcr program. OWB is currently comprised of II staff attorneys, 5 legal assistants, 

and an administrative assistant. 

The whistleblower program was designed to incentivize individuals to provide the 

Commission with specific, credible and timely information about possible federal securities law 

8 http://www.sec.gov/ruleslfinal/20 14/34-72936.pdf. 

9 http://Vv'WW.s.ec.gov/ocr 

11 
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violations, and thereby enhance the Commission's ability to act swiftly to protect investors from 

harm and bring violators to justice. Under the program, individuals who voluntarily provide the 

Commission with original information that leads to a successful enforcement action resulting in 

monetary sanctions over $1 million, may be eligible to receive an award equal to 10-30% of the 

monies collected by the Commission or in a related action. 

Since the whistleblower program went into effect in August 2011, the Commission has 

awarded more than $57 million to 27 whistleblowers. In Fiscal Year 2015 alone, more than $37 

million was paid to reward whistleblowers for their provision of original information that led to a 

successful Commission enforcement action with monetary sanctions totaling over $1 million. 

All payments are made out of an investor protection fund established by Congress that is 

financed entirely through monetary sanctions paid to the Commission by securities law violators. 

Because of the infommtion and assistance provided by the 27 whistleblowers who 

received awards under the program, the Commission was able to bring successful enforcement 

actions where over $400 million was ordered in sanctions, including over $325 million in 

disgorgement for harmed investors. Over $350 million has been collected in connection with 

these Commission actions as well as successful related actions. 

One of the primary activities of OWB is to evaluate whistleblower award claims and to 

make recommendations as to whether claimants satisfy the eligibility requirements for receiving 

an award. The Claims Review Staff, designated by the Director of Enforcement, considers 

OWB's recommendations in accordance with the criteria set forth in the Dodd-Frank Act and the 

Commission's final rules, and issues a Preliminary Determination. All Preliminary 

Determinations involving an award, as well as contested denials, are forwarded to the 

Commission for consideration, which then issues a Final Order. By the end of Fiscal Year 2015, 

the Commission and Claims Review Staff' had issued Final Orders and Preliminary 

Determinations with respect to over 390 claims for whistleblower awards. 

The number of whistleblower tips received by the Commission has increased each year of 

the program's operation. In Fiscal Year 2015, the Commission received nearly 4,000 

whistle blower tips, representing a 30% increase over the number of tips received in Fiscal Year 

2012, the lirst year for which OWB had full-year data. Since August 2011, the Commission has 

received more than l 4,000 whistlcblower tips. OWB has received whistleblower tips from 

individuals in every state in the country, as well as the District of Columbia, and from 

individuals in 95 foreign countries. 

OWB also continues to receive a significant number of award claims. In Fiscal Year 

2015 alone, OWB received more than 120 whistleblower award claims. OWB believes the 

uptick in whistleblower award claims and whistleblowcr tips is likely attributable to the 

increased public awareness of the Commission's whistleblower program and in response to the 

tens of millions of dollars that have been paid to whistleblowers under the program. 

In addition to managing the awards program, OWB is actively involved with the 

investigative staff in helping to ensure that employees feel secure in reporting wrongdoing to the 

12 
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Commission, without fear of reprisal from their employers. In June 2014, the Commission 

brought its first enforcement action under the anti-retaliation provisions of the Dodd-Frank 

Act 10 The Commission's action sent a strong message to employers that retaliation against 

whistle blowers in any form is unacceptable. The Commission also has filed several amicus 

curiae briefs in private cases pending in the federal courts to address the scope of the antiretaliation employment protections established by the Dodd-Frank Act The Commission argued 

that the employment protections should be understood to protect individuals at publicly-traded 

companies from employment retaliation who internally report potential securities law violations, 

regardless of whether they have separately reported the information to the Commission. 

In April 2015, the Commission brought its first enforcement action against a company for 

including langua~c in confidentiality agreements that impeded whistle blowers from reporting to 

the Commission. 1 Exchange Act Rule 21F-17(a) provides that no person may take any action to 

impede an individual from reporting information about wrongdoing to the Commission. This 

includes, for example, by enforcing, or threatening to enforce, a confidentiality agreement with 

respect to such reporting. Protecting whistleblowers' rights to report possible securities law 

violations to the Commission, and protecting whistleblowers from retaliation, continues to be a 

top priority for OWB. 

By protecting the confidentiality of individuals who report to the Commission pursuant to 

the whistleblower program, taking action against employers who retaliate against or interfere 

with their employees' ability to report wrongdoing to the agency, and awarding whistleblowers 

whose information leads to successful enforcement actions, OWB expects that the Commission 

will continue to receive high-quality tips that can be leveraged to detect and halt fraud earlier and 

more effectively. OWB anticipates that the whistleblower program will continue to be a game 

changer in the enforcement of the federal securities laws and the protection of investors and the 

marketplace. 

Conclusion 

In many ways the division and offices we supervise represent the evolving approach to 

securities regulation and oversight compelled by the recent financial crisis and guided by 

Congress. The Commission continues to make progress in adapting its operations to rapidly 

changing market conditions with the knowledge that our efforts will be ongoing. We look 

forward to continuing to work with Congress in this endeavor and we are happy to answer any 

questions you may have. 

10 In the Matter of Paradigm Capital Mgmt., Inc., File No. 3-15930, Rei. No. 72393 (June 16, 2014). 

11 In the Mauer ofKBR, Inc., File No. 3-16466, Rei. No. 74619 (Apr. 1, 2015). 

13 
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BRAD SIIERMAN 

UNITED STATES CONOR.ESS 

The Honorable Mary Jo White 

Chair 

April18, 2016 

The Securities and Exch!!flge Commission 

100F St.NE 

Washington, D.C. 20549 

re: Research Expenses 

Dear Chair White: 

Pu: (202) 225"5911 

FAX! (202) 225"5879 

As we discussed during your November 18, 2015 testimony in front of the House 

Financial Services Committee, the Financial Accounting Standards Board (F ASB) has not 

responded adequately to my concerns regarding its Statement of Financial Accounting Standards 

No. 2 ("F ASB No. 2"). I urge you to use your oversight authority to prompt action to modernize 

FASBNo.2. 

As you know, I have been among the strongest proponents for F ASB independence, both 

among members of the Financial Services Committee and the Congress as a whole. Nonetheless, 

FASB's continued inaction in addressing FASB No.2, an issue I consider of the utmost 

importance, has brought me near to questioning my faith in FASB. I must also question the SEC 

decision to rubber-stamp and enfurce F ASB pronouncements without any apparent concern for 

the impact of these pronouncements on the public interest. 

F ASB No. 2 requires accounting for expensing research and development expenditures in 

the year in which they are incurred. As a Certified Public Accountant, this rule has been an 

absurdity ever since its inception in 1974. 

To quote my old accounting text, Accoul1/ing Theory by Eldon Hendrikson, "To the 

extentthat R&D activities are carried out to develop new products, improve old ones, or reduce 

future operating costs, they are expected to benefit future periods rather than only the current 

period. Because future periods are expected to be benefitted, the knowledge gained is either an 

asset of the firm or an increase in the value of existing assets or of the firm as a whole. 

Therefore, according to the matching concept, the R&D costs should be capitalized and 

amortized over the period benefited." Virtually every accounting theorist would reach a similar 

conclusion. 

AECYClEO PAPEA 

0 .. ,:, .• 
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The Honorable Mary Jo White 

April18, 2016 

Page2 of3 

FASB No. 2, however, fails to treat research expenditures as an asset of the finn. Instead 

of recognizing the obvious benefit that research expenditures bring to both a company and the 

economy as a whole, FASB No. 2 concludes that research cannot be expected to bring a future 

benefit, and must be expensed. FASB's policy, ultimately, is to treat all research expenditures as 

a failure from the outset, regardless of the eventual benefit we know these projects often 

produce. 

F ASB No. 2 represents both bad accounting policy and poor common sense. If a 

company builds a new state-of-the-art research facility, it may capitalize the bricks and mortar 

that go into the building. It cannot capitalize the research done in the building. If a company 

spends billions to research a process that leads to a valuable new patent, it must expense every 

penny that goes into developing the patent. If they then choose to sell that patent, the purchaser 

is allowed to capitalize and amortize the purchase price. These outcomes make no sense, and 

worse, may create strong disincentives against companies making research investments. 

When you want to get less of something, you penalize it. When you want to get more of 

something, you incentivize it. Congress wants companies to conduct more research, which is 

why we have incentivized research with the establishment of the Research Tax Credit in the Tax 

Code (26 U.S.C. § 41). FASB, on the other hand, penalizes research by departing from good 

accounting theory - every dollar spent on research forces a reduction in reported earnings. 

Nonetheless, Congress is spending $7.63 billion over ten years in Research Tax Credits 

to mitigate the harm done by F ASB with FASB No. 2. 1 F ASB No. 2, under the auspices of the 

SEC, requires a federal tax credit roughly the si2:e ofthe SEC's budget. Of course, no one can 

detennine whether FASB No.2 does more or less harm to total research than the benefits 

provided by the Research Tax Credit, but it appears that FASB's continual mistake in its 

treatment of research probably does at least as much to decrease total research expenditures as 

the Research Tax Credit does to increase expenditures. 

In the area of leasing, FASB departed from 200 years of tradition in the name of 

accounting theory. In the area of research, FASB clings to approximately 40 years of tradition 

and stands strong behind the mistake they made in 1974, even though it diverges from 

accounting theory. Sometimes FASB prefers accounting theory; sometimes it prefers tradition. 

The only consistency between these two mistakes is that both harm the national economy by 

deterring research on one hand and commercial construction on the other hand. 

Do not believe statements by FASB that development costs may eventually be 

capitalized. I am not concerned about development costs. I am concerned about research costs. 

Congress wants to encourage research costs, which is why the Research Tax Credit exists. 

Also, do not be led astray by FASB's statements that they will make changes to FASB 

No. 2 in conjunction with the ongoing convergence discussions between FASB and the 

International Accounting Standards Board (IASB). F ASB has been providing this response for 

over a decade. To be sure, any change as a result of discussions with tile IASB will be a tiny 

tweak, not a real change. 

1 See https://www.jct.gov/publications.html?func=download&ide4677&chk=4677&no_html"'l. 

2 
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The Honorable Mary Jo White 

Aprill8, 2016 

Page3 of3 

I urge you to use your oversight authority to prompt FASB to modernize FASB No.2. 

cc: Senator Mike Enzi 

Senator Ron Johnson 

Rep. Mike Conaway 

Rep. Bill Flores 

Rep. Lynn Jenkins 

Rep. Patrick Murphy 

Rep. Steven Palazzo 

Rep. Collin Peterson 

Rep. James Renacci 

Rep. Tom Rice 

Tom Quaadman 

.3 

Sincerely, 

a~~ Brad Sherman 

Member of Congress 
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THE LABOR DEPARTMENT'S FIDUCIARY RULE: HOW A 

FLAWED PROCESS COULD HURT RETIREMENT SAVERS 
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EXECUTIVE SUMMARY 

individuals of retirement 

1 0UVER \~/YMAN, T!-lE RO!_F OF FlN,\N('!A!. ADVlSORS JN Tl!!·: lJS RFT!RFMENT MARKFT 16 {20!5) 

·' ld; DOI.'s 

Committee Hearing {sta!cment ofPcta Sdmeidcr), ,vupra note 

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Specifically, the report's findings include the following 

discord between 

senior 

rc<:ornrrrenctwllon and ignored the requirements 

the and bcnetlts 

approaches, As a Labor explained, "We think this would be 

difficult and would appn>eiably delay the project for very litl!e 

a 

of the "challenges in completing the !regulatory impact 

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24068.020

analysis]" and of the need to find literature and data that "can be woven together to 

demonstrate that there is a market failure and to monetize the potential benefits of 

fixing it." In another email, a Labor Department official discussed "building the case 

for why the rule is nccessary." 9 

The Labor Department rejected 0 IRA's recommendation to add language stating that the 

rule would !inns to continue to rely on all common lee and compensation 

practices . . . . The Labor Department responded that all fee practices will be 

permitted by the and that "[b]y deleting slightly soften this by 

leaving it at 'common and compensation practices. 

Investment advisors, in general, do not dispute the importance of acting in best 

interest of their clients, and many advisors already abide by a best interest standard. llowever, 

experts have criticized the proposed rule as burdensome and !2 and have challenged the 

Labor Department's claims that the rule will generate benefits for 13 They contend that 

the Administration has reported inflated numbers for the hann that results from investors relying 

on "conflicted advice,'' 14 with one expert opining "[y]ou don't have to be an economist to 

recognize the Administration's $17 billion point signiticantly overestimates the costs, if 

any, to investors relying on the 'conflicted of brokers." 15 Experts also caution that the 

proposal's conditions and requirements would create uncertainty for investment advisors and 

would increase compliance costs and risks. warn that the Labor Department's 

analysis overstates the rule's bene !its the rule actually result in net losses to 

retirement savers. '

6 These experts emphasize that the rule would actually hann the investors it is 

supposed to protect; the rule would drive up the price of investment advice and would ultimately 

decrease the availability of advice for low- and middle-income investors. 

A 2015 report estimates that the rule will cause a loss of retirement savings of$68-80 

billion per and will "jeopardize retirement readiness for 11.9 million lRA and retirement 

participants. Robert Litan, an economist and attorney who served as the associate director of 

Committee Hearing. supra 11ote 2 {statement of Robert Litan). 

STRATEGlES, supra note 13, at l; Senate l!ELP Committee Hearing, supra note 2 (statement of Peter 

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24068.021

smaH investors 

who 

Johnson 

Department. 

conm1unications between the 

and the SEC. However, to 

Due to 

18 Senate HELP Committee 

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int:omnation received. 

that 

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TABLE OF CONTENTS 

L INTRODUCTION 

EXPERTS 

The Labor Depa<tment Declined Incorporate Recommendations from Career 

into the Proposed Rule.... 8 

b. 

c. 

IV. 

INDUSTRY AND SOUGHT 

V. ADMINISTRATION 

OIRA Declined to 

Requests ..................................... . 

Staff Report 

Coopcrntion with 

.. 36 

to Chairman Johnson's 

.. .. 37 

39 

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I. INTROOUCTION 

On April 20, 2015, the of Labor issued a proposed rule to expand the 

definition of a tlduciary under the Retirement Income Security Act of 1974 

(ERJSA). 21 The Labor Department's proposed rule redefined the tenn "investment advice" to 

encompass activities that occur within pension and retirement plans, do not constitute 

investment advice under the existing definition of investment advice. The Labor Department's 

promulgation of this rule was the culmination of a effort by the Depmiment's 

Employee Benefits Security Administration 

Even before the latest proposal was announced, stakeholders began raising concerns that 

the rule adversely affect access to investment advice for low- and middle-income 

Americans. Additional questions were raised about the close involvement of the White House 

in shaping the proposaL" [n light of these concerns, Senator Ron Johnson, Chairman of the 

Senate Committee on Homeland Security and Governmental Aff.1irs. initiated an inquiry in early 

February 2015 26 

Under Senate rules and precedent, the Committee has legislative jurisdiction over 

intergovernmental relations and the regulatory of the federal government The 

Committee also has specific authority to ''the efficiency and economy of all branches 

and functions of Government with references to the operations and management of 

Federal regulatory policies and programs. Chairman Johnson initiated the inquiry pursuant to 

these authorities. 

Chairn1an Johnson to examine the Labor rulemaking process to 

ensure that the Department and fully considered from career, non-partisan 

professionals with expertise in the proposal's subject matter. As part of its inquiry, Chainnan 

Johnson requested infonnation and documents from the Securities and Exchange Commission 

21 CONCJ. RESEARCH SERV., R44207, DEPART1v1ENTOF LABOR'S 2015 PROPOSFD FtDUCIARY RUT.!: BACK(rROUND 

I (2015). 

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The Department's proposal to be a solution in search of a problem, driven by 

ideology rather than a market need. a result, some studies suggest that the proposal could 

result in losses to retirement of $68--80 billion each and will drive smaller investment 

advisors out of the marketplace. have criticized Labor Department's rule as 

burdensome and complex and caution the rule's conditions and requirements 

uncertainty for investment advisors and drive up costs and litigation risks. 

Ultimately. the rule will likely prompt investment to increase the 

offer to investors and to reduce the services they provide to middle-income 

U. THE LABOR DEPARTMENT DECLINED TO INCORPORATE 

RECOMMENDATIONS FROM SUBJECT-MATTER AND REGULATORY 

EXPERTS 

a. The Labor Department Declined to Incorporate Recommendations from 

Career Experts at the SEC into the Proposed Rule 

Under the Dodd-Frank Act. the 

broker-dealers and investment advisers. 

to examine existing regulations, evaluate their 

recommend fiduciary standards to the 

standards of care for 

lJodd-·J·nmK Act directed the SEC 

granted by the Investment Advisers in 1940, the SEC has regulated the 

investment industry. 44 The SEC is, therefore, the entity with the appropriate securities 

law expertise, to consider issues such as requiring a interest standard tor investment 

advisors. The SEC has reported plans to issue a uniform investment 

advice, which could result in '"two burdensome 

by the Labor Department and the SEC. 

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The Labor Department has authority under ERISA to employerprovided benefit plans. However. according to the former the Labor Department 

has significantly departed !rom its traditional view by attempting to regulate 

comf>ensat.ion and conduct for all of financial including registered investment 

and registered of broker dealers. At a minimum, given the SEC statrs 

expertise in securities and the potential for conflict between the two rules, the Labor 

Department should have ensured that its rule recommendations and addressed 

concems voiced by professional experts at the 

However, fi:mner SEC Commissioner Daniel 

Department did not collaborate with the SEC in the 

Gallagher called the a "fait accompli" and 

"merely perfunctory. Gallagher dispelled Dc:pa:rtmtent 

Thomas Perez's claims that the 

staff at the pointing out that Ctlmmt:sst•oncor 

conversations. Commissioner Gallagher wrote that, contrast to Secretary Perez's claims. 

"the [Labor Department's] actions, and the substance of the [Labor Depanment] Fiduciary 

Proposal. retlect a lack of concern for the [SEC's] views on these issues."·" He continued: 

Strikingly, the Fiduciary Proposal does not contemplate or even mention potential 

SEC rules or the SEC's existing regime fbr broker-dealers and 

investment advisers. lf the DOL were working 

with the SEC on an implcmentable standard, could have-~-and should 

included in its of substituted mechanism, in which 

compliance the DOL rules. 52 

Chairman Johnson has obtained information that 

position that the Labor Dcpatimcnt failed to work in good 

professional staff at the SEC. For more than a year 

promulgation of the proposed rule. SEC 

including a draft impact analysis. draft 

Commissioner Gallagher's 

with the career. non-partisan, 

Labor Department's 

ofthc rulemaking 

Interest 

Exemption), and on the point of sale Ul'""''""' 

between the Labor Department and the SEC staff reveal numerous instances in which the Labor 

Department requested advice from SEC staff on fundamental aspects of the proposal. but 

;old. 

'i! Id 

"!d. 

Briefing by Staff._ DOL, to Committee Stan~ HSGAC (Aug. 28. 2015) {notes on file with Committee). 

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disagreed with the SEC's recommendations and, in doing so, disregarded the SEC stall's 

subject-matter expertise. 

Although Perez publicly assured stakeholders that the Labor f1rn,•ctn'"'nt 

collaborated with the and with throughout government, 

including and especially the [SECj, documents by Committee paint another 

picture. A series of emails in July and August 2012 reveal disagreements between Labor 

Department staff and SEC stall' about the type of improper activity the proposal should measure. 

The SEC staff suggested that the should of interest, whereas the 

Labor Department sought to measure These men were 

classmates in a PhD program·--which may account lor the candid tone of the the 

email exchange the Labor Department disregarded an SEC expert's serious 

concerns about the rule. In one email, after a lengthy discussion of the proposal, a Labor 

Department staffer wrote to an SEC staffer:·" 

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R Ex. l. Email from Keith Bergstresser, 

SEC>DOL008056. 

Majority Staff Report 

Dep 't of Labor. to \ldatthew Kozora, (July 

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Good 

Matt 

Finally. SEC 

Labor Department 

documents the Committee received no indication of future discussion on this 

topic. The SEC staff also raised concerns about the Labor Department's reliance on 

nsvctJot<wv literature to draft the rule, which would result comparisons that ''have very 

economic meaning and thus no value to consumers. 

Email from Matthew Kozora, SF.C, to Keith Bergstresser. U.S. Dep'J of Labor {July 3L 2012, 

U.S. Dep't of Labor (Aug. 2. 20 !2, 

SEC (Aug. 2, 2012. 

1. Email fi·om Matthc\v Kozora, SEC lo Keith 1-krgstrcsscL lJ.S. Dep't of Labor (Aug. 2012. 

SEC-DOL008054 -00&055. 

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It is evident from these emails that the SEC's 

about the rule. The financial economist at the SEC 

repeatedly and serious concerns about!tmdamental 

However, not the Labor Depmtment 

went a step further by actually ae~nanamg 

proposal. 

of the rule. 

the Detomtmc1nt 

limited in camera The Committee. however, ultimately obtained the 

communications from another source. 

rule. The SEC stall's concerns included issues of clarity in 

the rule's "best interest" inadvcttent of a de minimis breach, contlicts 

with laws and FTNRA rules, and a of cost-bcnetit of 

70 ld 

The SEC's Labor 

staff with an limited subset of self-selected 

Notes arc on file with the Committee. 

from Lona Nallengara. SEC, to Sharon Block, DOL (Jan. 2(), 2015, 7:36PM), 

fhen~inafter Items of Concern Chart] (attachment is a chart containing items of concern 

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24068.032

insuf{lcient edits in to at recommendations, evidenced by the 

staff's follow-up on multiple 

, lo Sharon Rlnck, DOL (Jan_ SEC-DOL00327+-

SEC-DOL001274--

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24068.033

comments, 

Sharon. 

Documents received by the Committee and language in the pr•omut;,at•eo proposed rule indicate 

that the Labor Department declined to resolve these 

Staff neport 

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The "Best Interest" Standard 

of the term "hest interest'' in the 

recommendation, and stated that 

any additional explanatory language. 

Indeed, commentators criticized the '·best interest standard" in the pnJmulf~at<:d 

and recommended that the Labor Department clarify the standard's requirements. 

self-regulatory organization for the securities industry. focused on 

investment advisor to provide advice that is in the best ofthc 

the financial or other interests" of the investment advisor. FINRA explained that the 

regard to" phrase does not guidelines on limitations on compensation that varies 

depending on investment 

should control 

Finally, FlNRA questioned whether the Labor ucnar·tmem intended the best interest 

standard an investment advisor "to '"""''""'"'nrl 

reasoned that the Labor Dcnartment 

a statement by Secretary Perez, in which he 

lucrative for vo111-~-<"'"" 

Under a best 

for the client 

under a suitability standard, once you narrovil the 

are suitable, can rccommt~nd the one that is most 

mean a lower retun1 fbr the dienL 

need to choose the one that is the best 

Items of Concern Chart, SEC-DOL0032J4, 0032~9. 

Ex. 26, I ,etter from Marcia Asquith, Sr. Vice President & Corp. F!NRA, to DOL, at 6 · 8 

at&. 

!d at 7. 

"'!d 

Commentsl 

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F!NRA cautioned that such a standard ·'would impose unnecessary and untenable risks 

on fiduciaries.'' and explained that reasonable investment advisors may consider factors 

in evaluating products may reach different conclusions about which product is the "best" 

product for the customer. 

ii. Accidental Forfeiture (~f the Best Interest Contract l!,'xemption in Case (if a 

de jjfinimis Breach 

SEC staff raised a concern about language in the proposal's Best Interest 

which compliance with all federal and state laws. 

"could result in loss for trivial breaches," and 

De,pa.rtrne11t clarify that a de minimis breach would not disallow the 

language, if an advisor violated a state law unrelated to the 

ofnrrwi.rlin<Y investment advice, the advisor would not he compliant 

""""""''"" state laws, technically result in loss of the For example, 

an violation of a state law requiring a entrance to the 

building could result in of the exemption. The to implement 

the SEC staffs but failed to resolve the 

recommended that Labor Department make changes to this of the rule. 88 

at the SEC later advised Labor Depmtment otTicials that this problem had 

but the Labor Department failed to address the issue in the final proposaL 

Section Jl(a) of the Best Interest Contract Exemption in the 

requires ''the Advisor and Financial Institution enter into a written contract 

Retirement Investor that incorporales the terms /l{h)-(e}." 90 Section II( d), 

in tum, requires that ·'[t]he Financial and Affiliates will comply with all 

""!'"'"''"·" federal and state laws. As such, by its terms, the Section could cause an advisor to 

the exemption for a small breach of state contract law. 

feedback from career, 

of the promulgation 

""'~n:tm<Y the inadequate revision three 

the Labor Depa1tment declined to 

ltems ofCont:ern Chatt, SEC-DOL003234-003239. 

"as a result, failure to comply with will not disallow the "v'""''''"""\ 

3, Email from Lona Nallengara, to Sharon Block, DOL (Jan. SEC-DOL003274-

!l(a). RO Fed. Reg. 21,960, 21,984 (proposed Apr. 20, 2015) (to be coditicd at 

80 Fed. at 2!.984. 

t~attcneara. SEC, to Sharon Block. DOL (Jan. 26, 2015), SEC-DOL003274-

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that requires compliance with 

and creates the possibility of lcwfeiture 

of the exemption in ease 

iii. Lack of a Cost-Benefit Analysis for Alternative Approaches 

The Labor Dejpartment 

of the costs 

(EOs) 12866 and !3563. 

career SEC staff urged the Labor llenmtment 

all the alternative apJproaclJes 

expert"s rcoornmc11dation 

We think this would be extraordinarily difficult and would apjorecmllly 

for little return. The extensive qualitative <lescr·mtlmls 

alternatives included in the cun·ent [regulatory impact 

the bases for the alternative We 

trom OMB undertaking any quantitative 

)e''""'""'nt informed the Committee that foilowing OMB's review of the rule, the 

Dcnm1ment to complete analysis because it found the regulatory impact 

to be sutticiently 

SEC staff also recommended that the Labor Department 

associated with the possibility that the rule could decrease the of investment advice 

and drive tlnns to switch to registered investment advisor models broker-dealer 

models. The Labor Department responded that the regulatory impact analysis addressed these 

95 

at2!,984. 

~C~-IJVLV!l_,"'" 003239. 

1356:l. 3 C.F.R. 215 (2012). 

From the context of the document it 

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to the 

third 

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EOs !2866 and 13563 were enacted to process. EO 12866 

a federal agency to '"assess aH costs and regulatory alternatives. 

rc<mlauJ!lu." and provides that the assessment should include 

measures. supplements EO 12866, a federal 

to "''tailor its regula1ions to impose the least burden on ··to 

aoorc>achcl>." and to and alternatives to 

Department's proposed 

the "difficult" or "impossible'· threshold. 

detail, how 

agencies should conduct 

wold 

10\ !d 

111 !d at 12. 13. 112 ,)'ee 

to Committee Staff, HSGAC (Aug. 28, 2015) (notes on file with Committee). 

3 CF.R. 638 

(b)(5), 3 215 (2012). 

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not easily or monetized and on future pn~jectlons and unccrtainties. 11 ·; Tvvo full 

sections are dedicated to analyzing ''fltturc benefits and costs'' and ''forecasts 

about the future. OlRA instructs that while f(lrecasts about the future may be uncertain, 

those uncertainties should he should specify potential 

the benefits and costs associated scenario, and construct ranges of values. 

emnh<ascces that this is the minimum agencies should do, and that 

and calculate expected values based on those probabilities. 

The Executive Orders and the OlRA guidance do not from 

conducting a because the 

calculations future nrr>rec;twm. 

O!RA guidance indicate 

factors with intangible or properties. costs 

clearly do not fit into category because they are both countable objective. 

costs and hcnctits may involve complex calculations and future uncertainties is a 

nmLJisha!Jic obstacle. Jn fact, 0 !RA the importance 

or future uncertainties. 

cost and benefit of the rule, O!RA 's 

DPnMiment should have provided monetary and 

The Labor Department's of 

d,,,,,,.,ni•,inathat would be to costs and benefits, and thus the 

effort altogether, starkly contrasts with the guidance provided by O!RA. 

More of the SEC experts' 

in the rulemaking process and its 

The Labor Department's 

review is indicative of the 

Department's prioritization ofac<oderatinli 

thorough process that appropriately rel1cctcd lhe input of the 

b. The Lahor Hcpartmcnt Failed to Incorporate Principles from Existing 

Federal Securities l,aws ant! FlNRA Rules 

HNRA-the Financial Industry Regulatory Authority·-is the 

regulator of brokerage firms and exchange markets and ensures that the 

lLl Seeid 

ld at II. 

115 !d. 

at 14 15. 

!d at 12, !3; Order No. 12866; Exec. Order No. 13563. 

m OfRA, REGULATORY lMPACf ANALYSJS; A PRIMER, supra note lOK 

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J;rirly and honestly. 119 FINRA writes and enforces rules lor every 

in the United States, and federal securities laws and 

Rulcrnaking Board rules. FINRA has from the SEC to 

and flrms I(Jr securities laws. and 

FINRA more than 3,955 securities flrms with approximately 643,320 brokers. 

at the SEC 

the Labor Departm<onl 

and F!NRA 

Rulcmaking 

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Additionally. SEC staff identified several items of concern relating to the Labor 

Department's lack of incorporation of federal securities laws and FINRA rules. For example, 

SEC staff recommended that the Labor redraft definitions in the disclosure 

so that the provisions expressly referenced SEC 

that this would ensure that the Labor Department 

would receive complete and coJnparable data from investment advisors. 130 

llowcvcr, the Labor Department suggestion, instead merely including in the 

proposal's preamble a request tor comment "as to whether the terms used and definitions are 

suftlcient so that the information received will be reasonably comparable across different 

financial institutions." 131 

The Labor Department's failure to incorporate fundamental principles from federal 

securities laws and FINRA Rules lilfther that the Department did not thoroughly consult 

regulatory experts. This resulted in a rule have highlighted as problematic, in part 

because of the conflicts it creates with existing anticipated future regulatory frameworks. 132 

c. The Labor Department Declined to Incorporate OIRA's Recommendations 

into the Proposed Rnlemaking 

OIRA employs regulatory who catTy out the office's mission as the federal 

government's chief review and authority on Executive Branch rulemaking measures. 

Career, non-partisan, professional OlRA conduct reviews of draft and t!nal regulatory 

proposals, coordinate interagency review consider and review comments from 

outside groups on proposed rulemakings, on how rulemakings can best 

achieve the intended purpose. In several instances, that the Labor Department 

disregarded OIRA's recommendations and concerns the Department's llduciary rule. 

The Labor Department declined OIRA 's recommendation to add clarity to a particular 

of the rule. Specifically, OIRA instructed the Labor to add the qualifying 

"all" to describe the of common fee and ~ractices that the rule 

would preserve as exempt from prohihitcd rules. _n OlRA proposed the 

((,!lowing language: "the Department has worked to preserve beneficial models by separately 

proposing new exemptions from ERlSA's prohibited transaction rules that will broadly penni! 

finns to continue to rely on all common fee and compensation practices .... '· u 4 The Labor 

B. Ex. 2, Items of('oncem Chart. SEC-DOL003234--003239. 

Ex. 26, FlNRA Comments, at 11. 

Ex. 6, Conllict oflntcrest Rule, Apr. 8. 2015 Drat\, EBSA Pass Back, SEC-DOL004832. 

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Department 

will 

OIRA 's changes and ddcted "to 

by the exemptions" and 

by leaving it at 'c.ornmon fcc and compensation nr•rct•ce'' ' "" 

show that the Department ''"'""m""'" 

compensation packages. 

The Labor Dcpmtmcnt's deletion of the word "all" raises questions about the 

Or.nmrtm•ent commitment to The language in the emphasizes that the 

Department is committed lo existing models to the continuance 

of common fee and compensation practices. this language to 

because the Labor Depmtment retained its to 

compensation practices from the exemption. is difficult to un•der·sta:nd 

to and pennit the current compensation stmcturc in the 

the possibility of prohibiting some fee and compensation 

In another instance, OlRA questioned the Labor Department's term ''incidental 

advice" in connection with its discussion of the rule's seller's carve-out. Regulatory experts at 

OIRA cautioned that also "carve out advice given a 

broker under the and noted, where the 

Documents received by 

ucpa~mll>em fully responded to this concern. 

section of the preamble in rule contains the same language as the draft rule, 

the Labor Department did not adjust the to accommodate OlRA's concern, and 

suggesting that the Labor Department did not consider O!RA's comments. 

d. The Labor Department Did Not Fully Consider Concems Raised by the 

Treasury Department 

Department has enforcement authority over Individual Retirement 

are a creation of the tax code, and thus the Labor Department's 

Treasury on the rule is important. Given Trcasury~s 

proposed rule. 

11<; !d 

116/d. 

mld 

HR !d. (empha~is added). 

and to IR/\s, the Labor Department 

any concerns raised by Treasury officials about the 

J{ulc-R<ctwermmt Investment Advice ~ (b)( l )(i), SO Fed. Reg. 21,928, 21,957 (proposed Ape 

20.20 15) (to be codified at 29 CF.R. pts. 2509, 25!0). 

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Treasury officials and other experts have raised concerns about the Best Interest Contract 

Exemption (BIC exemption), because it would impose new requirements on fiduciaries with 

respect to IRAs. 141 lRAs are governed by the Internal Revenue Code, not by ERISA. Unlike 

ERISA. the Internal Code "docs not directly impose responsibilities of prudence and 

loyalty on fiduciaries. The Labor Department's rule. however, would create such 

responsibilities by requiring fiduciaries "to act in accordance with the Impartial Conduct 

Standards in transactions governed by the exemptions.'' 143 The rule's background section 

acknowledges that the proposal would more significantly increase requirements for advisors with 

respect to IRAs than it would tor advisors of accounts governed by ERISA Employee 

Retirement Income Security Act) because ERISA already requires those to meet 

prudence and loyalty standards. 

Former Assistant Secretary of Labor Bradford Campbell criticized this aspect of 

the rule as an effmt by the Labor Department to sidestep Congress, stating that ''[d]espitc 

their simultaneous creation Congress expressly chose not [to] apply the ERISA 

tiduciary standard to IRAs. According to Mr. Campbell, "the Department is 

attempting to do something through [the proposed rule] that Congress explicitly chose not 

to do." 145 

Treasury officials similarly voiced concerns about the Labor Department extending the 

reach of the rule to IRAs. Treasury otlicials commented that earlier amendments were made "to 

reflect Congressional intent," on the basis that was "being undermined by 

rules that [were] not reflective of current market practices. Treasury officials argued that this 

amendment, by imposing requirements with respect to accounts govemed by a different statute 

and under the jurisdiction of a different federal ''seems to fly in the face of the logic ... 

that these amendments are necessary to rellect intent.'' 147 The Labor Department 

responded by disagreeing and c!Tectively dismissing the Treasury Department's concern. The 

Labor Department wrote: 

We think there's a difference here between the regulation and the exemptions. 

The purpose of the regulation expanding the definition of 'fiduciary' is to ret1cct 

Congressional intent. However, the purpose of this exemption is to say that if 

Amendments to Class Exemptions, Apr. 2l, 2015 Draft, Treasury Comments (MaL 

Nov. 12, 2015. The 1m partial Conduct Standards require an advisor to act in the best 

not more than 

House Ways l4S fd (statement of Bradford Campbell)_ 

146 Appendix B. Ex. 7, Conflict ofintercst Rule, Treasury Comments, Mar. 21,2015. SEC-DOL005312. 

/d. 

Ma_jority Staff Report 

Committee on Homeland Security and Governmental Affairs 

United States Senate 

IFI0.118. 

25 
88 


24068.043

you're a under the [Internal Revenue Code] (and Congressional intent). 

and want to variable compensation, then have to 

conduct standards, even if they are not imposed by 

lRA advisors receive advice to !owand middle-income investors. would subject to the rule's 

conduct standards. Despite 

Jaw. the Labor Department 

IRA advisors under a different 

variable compensation as a proxy. 

comments specified in 

documents. it is 

Treasury Department cxperis. First. documents 

that the Departments discussed the Treasury Department's concern 

Department's initial to the Treasury Department. where it merely 

the Labor Department promulgated the 

including 

cH'LW<U<Hglhis draft and the aeconnma:nvin limiting the 

comments it received from Treasury 

Department pr<)mulf~at<'d does not contain language 

signifying that Labor Department rule with the Treasury 

Department's stated concerns. For these reasons, it is difficult to conclude objectively that the 

Labor Department fully considered the Treasury Department's comments. 

IlL EXPERTS IIA VE EXPRESSF:n CONCERNS ABOUT THE RULE'S 

ANTICIPATED IIARM TO MinDLE-INCOME AND SMALL !ltJSINESS 

INVESTORS 

raises concerns about both the 

The Committee has received dncmncnts 

expediting the drafting process at the 

addressing concems from industry experts. In instances, 

Denmiment o.s:rc<mr<-led advice from the SEC, OIRA, and Treasury, and to undertake a 

en•,1-l>en•·EI analysis of the rule. The majority stafffinds these actions especially 

Letter from Commonwealth Financial Network to DOL 

A sst Scc'y for Leg. Aft3.irs, Treasury, to 

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because of the concerns raised about the risk of the rule's anticipated harm to middleGenerally. industry including investment advisors, support a best interest 

standard, but have criticized rule on the grounds that it is complex and burdensome. 

For example, Peter Schneider. the President of Primcrica, to Congress that "agree[ s J 

that firms and their representatives should always act in their clients' best interests. He 

explained that he is concerned ·'that the and uncertainties of the [Best Interest 

Contract Exemption] are so and that the exemption is n either 

administratively nor on<wJuonaJ 

Similarly, tonner SEC Commissioner Daniel Gallagher has harshly criticized the rule, 

calling it a '"mess;' in part because advisors who adhere to a best interest still risk 

nonc.<1mnli:m,ce with the rule because of its many complicated recjmJren1er1ts. 

has cautioned that the Labor Department's rule result in the "'ellim,im<ticm 

entire class of accounts" t(w investors and wonltl subject advisors to "unlimited liability. 

Other experts and observers have also raised concems that the conditions and requirements the 

rule imposes arc ambiguous and unworkable, which will increase litigation risk and 

costs. Experts anticipate that advisors will incur initial compliance costs of $215 

annual maintenance costs of $5.1 million, resulting in increased for retail investment advice 

by 73% to 196% as a result of the Labor Dcpattment's proposal. 

Additionally, experts contend that the Administration has inflated the hmm that results 

from investors relying on •'conflicted advice.'' The White House and the 

claim that conf1icted advice from brokers costs investors $17 billion per 

chief economist Lewis has that the $17 billion estimate based on a calculation 

di;;cnon2tncies in the data and that used outdated data from the 1990s 

ru>•"m<. a''fHU note 43; see also DELOJT!E DLVELOP\1ENT LLC, REPORT ON TirE 

ANTJ('JPATIJ) OPERATIONAL lMfACTS TO BROKl~R-DEAfA'RS ()F'rflE DEPAR'rME:'-IT OF l,ABOR'S PROP()SED CO'KFlJCT 

OF fNTEREST RULE PACKAGE (2015) (reporting similar findings). 15(' OFFICE OF Tl !E PRESIDENT, THE EFFECT'S OF CONFLICT!:!) lNVESTMFNT AD\'K TON RFnREMENT SAVJN(JS 

(2015). 

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24068.045

and 2000s. Mr. Lewis slated, '"[y]ou don't have to be an economist to recognize the 

Administration ·s $!7 billion talking point the costs. if any, to 

investors relying on the 'conflicted advice' 

Experts have focused, in 

small-account owners---small The Small Business 

Administration has commented that the mle '"would 

associated with smaller limit financial advisers' abilitv to offer 

to ultimately lead advisors to stop 

providing retirement services to small businesses. Similarly. fonncr Assistant Secretary of 

Labor Bradford testified that tbe rule ·'likely will hann the very retirement investors it 

Mr. Campbell echoed the Small Business Administration's concems that 

cost and reduce the availability of advice to small and smallaccount IRA owners. Finally, have to an "advice 

the United Kingdom (U.K.) as a in the 

identical to the Labor Department's rule. According to expe1ts. it is ·'widely accepted 

in the U.K." that ·'middle- and lower- income savers in the U.K. are being cut off from 

investment advice." Ui3 United Kingdom government has "launched a major review of 

exactly that advice gap. 

First, the rule contains a carve-out that will not 

Carve-Out" exempts an investment advisor limn fiduciary when the advisor sells or 

markets materials, as long as the advisor discloses that advisor is paid to sell orcmr1etarv 

financial product and is not advice. However. the 

advisors to small businesses Carve-Out based on assumption that 

small businesses lack financial Small businesses and ERISA experts have 

voiced concerns that the rule small businesses of access to guidance on investment 

Dillon Asst. 

DOL, at (July 

U.K. LAllNC'JILS RFV!FWOF";-\DVICEGi\1' .. FURSMAU. ACCOtJNTS 

RULEC!!ANCiE WlTll EFFECTS iDFNTlC/\J, TO Wl!AT DOl. NOW PROPOSES (2015). 

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24068.046

that arc otherwise permitted the carve-out. 167 Small businesses have additionally 

the Labor Department's that small businesses lack the 

to with investment without statutorily At 

Committee on Health, Education, Labor 

business owner testified: 

J would not be able to run a successful business if I were not able to understand 

when i am involved in a sales discussion. . . . The assumption that small plans, 

nmii<·.inonts and IRA owners cannot understand the difference between sales and 

not match my real world experience. The 

participants, IRA owners and small plans 

"""'""'c' that it of plans under the 

the services 

Depattment can 

same kind of 

Former Assistant Secretary Campbell similarly criticized the carve-out, "there is 

no clear basis to believe that for financial sorJhi,;tic:ation, no basis 

to treat every IRA ""ncr as is 

Additionally, expcris have voiced concerns that the Best Interest Contract Exemption 

is unworkable and that finns will not usc it. The RIC exemption allows certain 

orurKcr-urcarurs and llduciarics to receive that would otherwise be pn>motcuu, 

such as commissions. To take advantage exemption, the investor and 

a contract acknowledging fiduciary status. The advisor must act in the best 

must make numerous disclosures to the client and to the Labor Department. 

contend that the BlC exemption is unworkable and will increase the cost of investment 

and vviH, decrease access to investment services for smaH 

investors. Experts explain that BIC exemption conditions and requirements f<lr 

advisors that are ambiguous, and advisors at risk for penalties and 

lawsuits, class action caution that investment firms 

to usc the me exemption. 

16$/d 

16'1/d 

170 ld (statement 

tll CONU. RESEARCH SERV IN FOCIJS, !Fl03 !8. 

12,2015. 

ld 

!d.. 

2 (statement of Darlene Miller). 17

~ Jd (stdtements ot Darlene Schneider). 

ld; I louse Ways & Means Committee Hearing. supra note .n (statements of Judy VanArsdale and BradfOrd 

Campbell). 

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According to experts, the unworkability of the BIC 

income, small-account owners' access to investment services. 

not use will likely convert their COitnnorsswn-tJasea 

accounts. accounts are more expensive to coJnnlis:sion-llascd accounts 

and. thcrciOre, often require account minimums 

caution that these costs wi II inhibit access to investment services small 

could result in losses in retirement of as much as $68-80 billion per 

Experts 

and 

scrv ices to small account owners. fees will present 

who cannot aft<lrd to pay llat rates and 

However, these large investment linns are not the ones that will !eel the most significant 

effects ofthe rule. Rather. the rule is to harm small- and mid-size investment finns. For 

.Judy VanArsdale. the eo-owner 

before the House Committee on Ways and Means 

As a small wealth management company, Ms. VanArsdale's 

accounts, with more than 800 accounts containing less than 

explained that the rule risk because of its lack 

state-law class action lawsuits. Ms. VanArsdale stated that, as a owner, 

feels business to increased business and litigation risk. 

coJmt•:>rt,able using 

brokerage accounts. 

risk, "small businesses ... may not feel 

would be restricted from 

Senate HELP Committee llearing, supra note 2 (statements of Darlene Miller and Peter Schneider): House Ways 

Committee note 47 (statement ofBradf()fd 

Senate HELP House Ways & Means 

!d. 

fd IR6/d. 

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24068.048

regime, small- and mid-size investment finns~·~and the middle-class consumers they 

scr·v!(;r~····l1avc less tolerance to weather such changes. 

IV. THE AHMINISTRATION WAS PREDETERMINED TO REGULATE THE 

INHUSTRY ANn SOU(:HT EVWENCE TO .IUSTIFY ITS PREFERREU 

ACTION 

The Labor Department refused to provide Commi!tce with its communications with 

the White! louse. However. the Committee obtained some of these communications t!·om 

The communications indicate that the Labor Department and the White House 

were IO regulate the and sought evidence action. 

The communications also that the House may have 

rulemaking. in conflict with Administrative Procedure Art. 

In an email to Brian Dccse---a senior political advisor in the Executive Office of the 

Prcsidenl··-··a Labor advisor wrote of the the 

he noted. "we need the 

other data we have not yet identified can be 

discussed plans packaging the rulcmaking re-nr<JO<lsal. that 

the Labor Department intended to use to 

Office of the President. et aL 

, to Brian . Dc('.<:c. Ofilce of the President, et al. (Nov. 

12866 § l (a), 3 CF.R. 638 ( !99-1-): sec also Order No. 

an agency must ''propose or adopt a regulation only upon a reasoned dct•ormina'tion 

its costs"). 

Order No. l28b6 § l(a) .. 1 C.F.R. 638 (1994). 

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hackwards~~~thcy first determined that they wanted to create the rule. then searched for evidence 

to justity it. The in which the Labor Department and the White !louse the 

regulatory impact is opposite to the methodology required by order. 

The Administrative Procedure Act vests control ora rulcmaking in the 

n:,;u~<"mm. The Executive Onicc of the President~~ ~including OIRA. 

ultimately each 

fiduciary rul·emakrng. 

owns its 

broadly across the executive branch, but 

With to the Labor Dcpm·unentt~s 

appears 

Documents that the Committee received suggest that the 

political in the Executive Office of the President first. level email 

"''""'""''"'""'""between the Labor and the White Honse indicates that White House 

advisors may have exceeded their function in the rule. For instance, in the 

email discussing a GAO report that the Labor Department felt build a case fc1r the rule, a 

Labor official numbers and direct from the report 

to the suggests that Mr. and other 

advisors within the White House. were involved in the basis for the rule and 

regulatory impact analysis on a granular and collaborative 

Additionally, in October and November 20! I, the White House"s National Economic 

Council convened a series the Labor Department, the the 

Department, and the White House to rule"s economic analysis. These dis:cwssi<)I1S 

to have been more than mere coordination Rather, it seems that White House 

were involved in developing material to justify need for the Labor Department's 

proposaL 

f\1oreover. Assistant 

"main architect'" of the 

House during the Obama A<l:nnntstrat 

!d 

Staff Report 

Borzi, who has been described as the 

twelfth most visitor to the White 

visited the White House 

"---·-"'----on Homeland Security and Governmental Affairs 

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32 
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24068.050

338 times. m Two other senior Labor 

tl·equent White House visitors, with 369 

and sixth most 

a White House memorandum entitled "Draft Conflict of Interest Rule for 

further illustrates the White House's significant involvement in the 

The memorandum, circulated by White l louse Council of Economic 

(CEA) Jason furman and CEA member Stevenson, to the President's 

John Podesta. Susan Rice, and 

existing consumer protections on 

tc1ur months later. 

V. THE ADMINISTRATION OBSTRUCTED CHAIRMAN .JOHNSON'S INQUIRY 

BY LIMITING THE INFORMATION THE COMMITTEE WAS ABLE TO 

OBTAIN 

ln the course of conducting 

Johnson experienced tremendous 

Labor withheld documents and even went so as to urge the SEC-an independent 

OlRA also withheld documents. The 

with Chainnan Johnson's oversight 

docmnents and has hindered the 

a. The Labor Department Remains Uncooperative with Chairman Johnson's 

Requests for Information and Documents from Febrmny 2015 

Chairman Johnson wrote a letter to the Labor Department on February 5, 

re<mc:sl!n<' information and documents to the Department's anticipated rule. After the 

Denmtment htilcd to produce in response Chairman 

Johnson the requests in another letter on March 17. 2015. Johnson 

requested communications about the Labor Department's rulemaking between the Labor 

197/d 

ld 

l'l'i Memorandum from Jason funnan, Chairman, White House Council ofEcon. Advisors, and Betsey Stevenson. 

White House Council of Econ. Advisors, to White House St'nior Advisors (Jan, l3, 20 J 5). 

A, I, Letter from Chairman Johnson to 

A, Ex. Le-tter from Chairman Johnson to 

MaJnrity Staff Report 

Perez, DOL 

Perez, DOL 

5. 

17, 

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United States Senate 

33 
96 


24068.051

Depmtment and the SEC and between the Labor Dcpm-tmcnt and the White Housc."13 By its 

own the Department has not produced material responsive to Chainnan Johnson's 

Spccit1ca!ly, the Labor Dcpmtmcnt to 

Johnson's for communications 

ln Chairman Johnson signaled his 

nomination to be Labor Department's Assistant Secretary 

Intergovernmental Atfairs because of the failure 

head of the Office of Congressional lntcrgovemmcntal Affairs-to 

requests. the Labor Department int(mncd the 

no responsive documents Department however, refused to explain 

the Department came to this conclusion or what type of search the conducted. 

The Committee later received, from another source. between the 

and the White House about the rulemaking. Still, later, in December 2015. the 

refused to the requested materials and to confirm 

White House to pruduce the materiaL 

The Labor Department has not !u lly to Chairman Johnson· s 

communications between the Department and SEC_ The Labor Department 

a limited subset communications between the Dcparttnent and 

short briefings. The communications the Labor Department produced are mostly 

20 15); ser also Email fn.)m Committee Staff, 

call); 

with 

(on file with Committee). 

002458: Emails between Committee Stall 

20 15) (on file with Committee). Mr. Jayaratnc's staff, moreover, 

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24068.052

scitcctnJ,,ngmcctings and do not address substantive aspects of the rule drafting 

Moreover, the Department documents after the Chairman made 

but similar request to the SEC Additionally. during the briefings, 

Department lawyers unilaterally limited the subject matter and timing of the briefings, 

leaving many questions unanswered. 

Regarding the Labor Depattmcnt and SEC communications, the Lahor Depmtment 

refused to certify that the communications to the 

universe of communications to 

Depmtment refused to provide m.,,..,JJJatJoJJ 

the methods the Department used to identify res;ponsiivc 

conlinned that these communications, in fact, not constitute the full universe 

communications, Rather, it that the Labor Department combed through its 

communications with the and dclibcmtcly omitted the large of communications 

that would inform Chairman Johnson's The Committee has documents from 

another source that contain many between the Labor Department and the SEC 

that the Department omitted from its production. The Labor Department has acknowledged to 

the stall that additional responsive material exists, though it refuses to produce such 

In July 20 !5, Chairman Johnson spoke with Perez about the outstanding 

document requests. The staff has also cul!wmu"'"'"" directly with Mr. about 

the Labor Department's responses. these interactions. and 

Johnson's continued objection to Mr. Jayaratne's by the Senate, the Labor 

Department still refuses to comply fully with the Chairman's It seems that the Labor 

Department has only seriously in discussions about 

in an effort to advance 

placed unilateral time and content restrictions on these 

outside the Emails between ( 'ommittce 

(on file 

2015,5:14 PM) (on file with 

Committee). 

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United States Senate 

Staff. 

35 
98 


24068.053

despite repeatedly refusing to produce responsive material, the Labor uc~arrute~" 

has not claim of privilege on the \Vithheld material, and has to 

int(mnation about scope, nature, and contents of the withheld material. The 

Dc,nartmcnt's stated reasons for noncompliance arc ali the more given that its 

authority derives ti·om an Congress to the 

oversight authority 

Ultimately. Congress also 

the Congressional Rc,1icw 

Comrnillee ought to have Labor Department should be 

completely willing to provide access· ·to all documents and communications related to the 

rulcrnaking. 

\Vith little cooperation from the Labor Dcpartn1cnt. Chain1mn Johnson vvrotc to other 

to seek information about the Under Chainnan Johnson and 

the Chairman threatened to the SEC 

provided a number of documents to that offered tremendous 

rulemaking. Similarly, FlNRA also voluntarily assisted in providing useful 

b. The Labor Department Attempted to Interfere with the SF:C's Cooperation 

will! the Chairman's Requests 

wuuurcmw1g information thmr the Committee, the Labor Dcpar·tment 

it had the SEC---an independent set np to 

Branch~-to Chairman Johnson's 

to the SEC for documents in the and 

to the SEC precisely 

initial requests. 

The Labor interference with Chairman Johnson's request to the SEC was 

inann1conriatc and of the overall in responding to the 

inquiry into the rulcmaking. made a to the 

SEC for documents the possession and control of the 

Office & 

r\sst Scc'y Jaynratnc, DOl,_ to Chairman Johnson 8, 20 15). 

tfom Committee Stafl HS(IAC, to Adri /\sst. Scc'y. Office ofCong. 

!ntergovemmental Affairs. DOL (July 8. 2015.6:56 Committee). 

Ma,iority Staff Report 

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24068.054

Department had no standing to intcdcrc. For reasons unknown to the majority stall the Labor 

Department was unwilling to went out of its to attempt to others from 

pr<JdrrciJng-----<locurrtertts to the Cr•m•11ittee about its work on important 

c. 01RA Declined to Provide a Full aml Complete Response to Chairman 

Johnson's Requests 

Chairman Johnson wrote a letter to OIRA on May 

documents to OlRA·s review of the Labor Dcpartntcntt's 

information and 

After O!RA tailed 

mid 

Chairman Johnson's request stemmed fi·om concern about whether OlRA conducted a 

and thoughtful review of the rule. O!RA expedited its review, as evidence by the fact 

Labor the mlejust fifty days after OIRA received the 

to ensure that O!RA conducted a and 

information: 

l. Please provide all drafts ofthe Labor Department's proposed rulemaking. including 

comments and suggestions to the drajls. 

2. Please explain why O!RA required considerably less time to review the Labor 

Department's than the review time f(lr other l ,abor 

Department other significant rules. 

3. Please explain how OIRA im:nrno•mt<o~ sngl;cstro1ns from other Executive Branch 

departments and agencies, as lnto review of the Labor 

Department's proposed rulcmaking. 

4. Please explain how the version of the proposed rulcmaking incorporated OlRi\ 's 

suggestions. 

A, Ex. Letter from Chairman Johnson to l\dmin'r 

A, Ex. 8, from Chairman Johnson to 

I 8, Letter frorn Admin 'r Shelanski, OlRA, to Chainnan Johnson 

Letter from Chairman Johnson to Admin 'r Shclanski, OlRA 

Majority Staff Report 

Committee on Homeland Security and Governmental Affairs 

U niled States Senate 

37 
100 


24068.055

5. Please explain how O!RA evaluated the Labor Department's rulcmaking 

with respect to Executive Order !3563"s requirements for cvv.cwvaw.m with other 

agencies and consideration of flexible approaches. 

OJRA"s May 18. 2015 response to the Chairman provided information about 

O!RA"s process that to O!RA"s review Labor Department's 

its review Labor Department"s proposal. OIRA provided only 

OIRA devoted the time and resources 

consistent with EOs 12866 and 13563. 

number of relevant Executive Branch agencies. O!RA then 

this draft on April 14. 2015. As background. EO 12866 

days to review significant actions, though 

extension. The amount of time to 

but OJRA does 

This answer lacked any specific inli.mnalion about the review process that Chairman 

Johnson requested. 

OIRA 's January 20, 

Chairman Johnson requested. 

letter similarly lacked the specific inilmnation that 

OlRA simply stated: 

Regarding the rule under review. l can 

assure you that devoted the time resources necessary to ensure the 

review was accordance with EOs J 2866 and I 3563. The amount of time 

needed to complete review on any given rule varies, hut OlRA endeavors to 

complete the ;;bile The 

revievv of the 

relevant Federal 

this response contains a conc!usory statement void 

OJRA's review of the Labor rule. OlRA's 

failed to satisfy Chairman Johnson's request. O!RA 

hut the drafts do not contain comments or suggestions, 

17, from Admin'r Shdanski, om.A, to Chairman Johnson (May 18, 2015). 

1 !t Letter from Admin'r Shelanski, O!RA to Chairman Johnson (Jan. 20, 20!6). 

Majority Staff Report 

Committee on Homeland Security and Governmental Affairs 

United States Senate 

38 
101 


24068.056

OlRA also provided a list of meetings it took with oft he public 

to the rule, and the materials to OlRA at the meetings, The 

rm,ou:cnons and that provided to the Committee fail to offer any 

insight into review of the Labor Department's proposaL 

VL CONCLliSION 

rule has revealed that 

at expense 

experts, 

career, regulatory experts at 

concerns to the Labor Department about the 

rule, Yet, documents that the Committee indicate that the failed to 

implement numerous recommendations from these government in other agencies. 

Chairman Johnson also encountered opposition and noncooperation from the Labor 

Department throughout its examination of the calling into question the 

commitment to transparency and to Congress, From the 

mrorrnarron that the Committee was able lo uncover, the Department's Oawed process in 

"Conflict of Interest'' rule could ultimately hurt American retirement savers, 

or not, the rule threatens to restrict access lo retirement advice 

fc1r those Americans who need it 

'"td 

ld 

Staff Report 

Conunittcc 011 Homeland Security ant! Governmental Affairs 

United States Senate 

39 
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24068.057

Chairman Scott Garrett 

Questions for the Record for Capital Markets & GSE Subcommittee Hearing Entitled 

"Continued Oversight of the SEC's Offices and Divisions" 

April21, 2016 

Questions for Thomas Butler, Office of Credit Ratings: 

1. As you are aware, the SEC adopted significant new rules and rule amendments for 

credit rating agencies in August 2014, which you note in your testimony mostly 

became effective in June 2015. 

Response: 

a. Then-Commissioner Gallagher expressed significant concerns about 

amendments to Rule 17g-8 in his dissent, in particular a concern that the 

amendments "awkwardly and ineffectually [impose) upon NRSRO's a 

mandate to take into consideration" a set of factors that are not explicitly 

identified. Given this ambiguity, how has your staff determined whether an 

NRSRO properly "takes into account" a set of factors and is therefore in 

compliance with the final rule? 

In the amendments to Rule 17g-8( d) 1

, the Commission explicitly identified the following 

control factors that an NRSRO must take into consideration when establishing, maintaining, 

enforcing, and documenting an effective internal control structure governing the implementation 

of and adherence to policies, procedures, and methodologies for detennining credit ratings: 

Specifically, pursuant to Rule 17g-8(d), an NRSRO when establishing an internal control 

structure must consider the following factors: 

1. controls reasonably designed to ensure that a newly developed methodology or proposed 

update to an in-use methodology for determining credit ratings is subject to an 

appropriate review process (for example, by persons who are independent from the 

persons that developed the methodology or methodology update) and to management 

approval prior to the new or updated methodology being employed by the NRSRO to 

determine credit ratings; 

2. controls reasonably designed to ensure that a newly developed methodology or update to 

an in-use methodology for determining credit ratings is disclosed to the public for 

consultation prior to the new or updated methodology being employed by the NRSRO to 

determine credit ratings, that the NRSRO makes comments received as part of the 

consultation publicly available, and that the NRSRO considers the comments before 

implementing the methodology; 

1 17 C.F.R. § 240.l7g-8(d) (Rule 17g-8(d)) 
103 


24068.058

3. controls reasonably designed to ensure that in-use methodologies for determining credit 

ratings are periodically reviewed (for example, by persons who are independent from the 

persons who developed and/or use the methodology) in order to analyze whether the 

methodology should be updated; 

4. controls reasonably designed to ensure that market participants have an opportunity to 

provide comment on whether in-use methodologies for determining credit ratings should 

be updated, that the NRSRO makes any such comments received publicly available, and 

that the NRSRO considers the comments; 

5. controls reasonably designed to ensure that newly developed or updated quantitative 

models proposed to be incorporated into a credit rating methodology are evaluated and 

validated prior to being put into use; 

6. controls reasonably designed to ensure that quantitative models incorporated into in-use 

credit rating methodologies are periodically reviewed and back-tested; 

7. controls reasonably designed to ensure that the NRSRO engages in analysis before 

commencing the rating of a class of obligors, securities, or money market instruments the 

NRSRO has not previously rated to determine whether the NRSRO has sufficient 

competency, access to necessary information, and resources to rate the type of obligor, 

security, or money market instrument; 

8. controls reasonably designed to ensure that the NRSRO engages in analysis before 

commencing the rating of an "exotic" or ''bespoke" type of obligor, security, or money 

market instrument to review the feasibility of determining a credit rating; 

9. controls reasonably designed to ensure that measures (for example, statistics) are used to 

evaluate the performance of credit ratings as part of the review of in-use methodologies 

for determining credit ratings to analyze whether the methodologies should be updated or 

the work of the analysts employing the methodologies should be reviewed; 

I 0. controls reasonably designed to ensure that, with respect to determining credit ratings, the 

work and conclusions of the lead credit analyst developing an initial credit rating or 

conducting surveillance on an existing credit rating is reviewed by other analysts, 

supervisors, or senior managers before a rating action is formally taken (for example, 

having the work reviewed through a rating committee process); 

11. controls reasonably designed to ensure that a credit analyst documents the steps taken in 

developing an initial credit rating or conducting surveillance on an existing credit rating 

with sufficient detail to permit an after-the-fact review or internal audit of the rating file 

to analyze whether the analyst adhered to the NRSRO' s procedures and methodologies 

for determining credit ratings; and 

2 
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12. controls reasonably designed to ensure that the NRSRO conducts periodic reviews or 

internal audits of rating files to analyze whether analysts adhere to the NRSRO's 

procedures and methodologies for determining credit ratings; as well as 

any other controls necessary to establish an effective internal control structure taking 

into consideration the nature of the business of the NRSRO, including its size, 

activities, organizational structure, and business model. 

With respect to maintaining the internal control structure: 

13. controls reasonably designed to ensure that the NRSRO conducts periodic reviews of 

whether it has devoted sufficient resources to implement and operate the documented 

internal control structure as designed; 

14. controls reasonably designed to ensure that the NRSRO conducts periodic reviews or 

ongoing monitoring to evaluate the effectiveness of the internal control structure and 

whether it should be updated; and 

15. controls reasonably designed to ensure that any identified deficiencies in the internal 

control structure are assessed and addressed on a timely basis; as well as 

any other controls necessary to maintain an effective internal control structure taking into 

consideration the nature of the business of the NRSRO, including its size, activities, 

organizational structure, and business model. 

With respect to enforcing the internal control structure: 

16. controls designed to ensure that additional training is provided or discipline taken with 

respect to employees who fail to adhere to requirements imposed by the internal control 

structure; and 

17. controls designed to ensure that a process is in place for employees to report failures to 

adhere to the internal control structure; as well as any other controls necessary to enforce 

an effective internal control structure taking into consideration the nature of the business 

of the NRSRO, including its size, activities, organizational structure, and business model. 

With respect to documenting the internal control structure: 

I 8. any controls necessary to document an effective internal control structure taking into 

consideration the nature of the business of the NRSRO, including its size, activities, 

organizational structure, and business model. 2 

Generally, the staff assesses compliance with Rule 17g-8(d) by interviewing relevant 

NRSRO staff and reviewing internal documentation to evidence that the firm considered each of 

the specified control factors. As discussed in the Adopting Release for Rule 17g-8(d), in 

2 See Release No. 34-72936, National Recognized 

Statistical Rating Organizations at 667-81 (Aug. 27, 2014); 

[79 FR 55077 (Sept. 15, 2014)], available at https:llwww.sec.gov/rules/final/2014/34-72936.pdf. 

3 
105 


24068.060

considering a given factor, an NRSRO should determine whether it would be appropriate for the 

firm's internal control structure. 3 The Commission did not mandate that a particular factor be 

implemented, only that it be considered by the NRSRO. 

Response: 

b. In his dissent, Commissioner Gallagher also used the phrase "thought crime" 

to describe the ultimately adopted rule text that prohibits a person within an 

NRSRO participating in the rating process to be "influenced by sales or 

marketing considerations." 

i. How do you address Mr. Gallagher's notion that the Commission can 

basically prosecute a state of mind, given the prohibition docs not 

require an actual action to be taken? 

ii. Commissioner Piwowar also noted that this rule text "sets an 

impossible standard for compliance and has no limiting principle." 

Commissioner Piwowar also importantly noted that "it is not just 

management at the NRSRO whose motives could be questioned; every 

NRSRO employee including those involved in ratings determinations, 

has an interest in the success of the enterprise." How do you ensure 

that the SEC does not abuse this overly broad prohibition to allege 

violations? 

Section 15E(h)(3)(A) of the Securities Exchange Act of 1934 (Exchange Act) directed 

the Commission to issue rules to prevent the sales and marketing considerations of an NRSRO 

from influencing the production of credit ratings by the NRSRO. Given this statutory language, 

the Commission included two prongs to the absolute prohibition in Rule 17g-5( c )4 prohibiting a 

person within the NRSRO who participates in determining or monitoring the credit rating, or 

developing or approving procedures or methodologies used for determining the credit rating, 

including qualitative and quantitative models from also: (i) participating in sales or marketing of 

a product or service of the NRSRO or a product or service of an affiliate of the NRSRO; or (ii) 

being influenced by sales or marketing considerations. 

Additionally, the NRSRO must include with each credit rating action an attestation 

signed by a person within the NRSRO stating that the person has responsibility for the rating 

action and, among other things, no part of the credit rating was influenced by any other business 

activities. 

The Adopting Release for Rule 17g-5(c) provided several examples of sales and 

marketing activities and the Commission noted that other scenarios would need to be evaluated 

3 See Release No. 34-72936, National Recogni:zed 

Statistical Rating Organizations at 65 (Aug. 27, 2014) [79 FR 

55077 (Sept. 15, 2014)], available at https:l/www.sec.gov/rules/final/201 4/34-72936.pdf. 

4 17 C.P.R.§ 240.17g-5(c)(2015)(Ru1e 17g-5(c)). 

4 
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24068.061

based on the particular facts and circumstances. 5 In the Adopting Release, the Commission also 

discussed the possible channels of influence that should be considered, such as: 

• Compensation arrangements that may incentivize analysts to produce inflated credit 

ratings to increase or retain the NRSRO's market share; 

• Performance evaluation systems that reward analysts who produce inflated credit 

ratings to increase or retain the NRSRO's market share; 

• Compliance personnel who unduly influence credit analysts to inflate credit ratings in 

response to complaints by clients; 

• Clients such as rated entities who pressure analysts to produce inflated credit ratings 

to retain their business; or 

Managers who are not involved in sales and marketing activities but may seek to 

pressure analysts to produce inflated credit ratings to increase or retain the NRSRO's 

market share. 6 

The staffs annual examinations ofNRSROs include testing compliance with Rule l7g5(e). This includes (I) reviewing internal documentation at the NRSRO, (2) reviewing staff 

email or other written communications, (3) conducting interviews of persons participating in the 

rating process as well as persons involved in sales or marketing activities, (4) observing the 

physical separation of such persons, and (5) reviewing the attestation that must be included with 

each credit rating action. 

As a component of the examination, OCR staff provides the NRSRO with 

recommendations relating to the findings to which the NRSRO is required to provide a response. 

The resulting response is then evaluated in subsequent examinations to assess whether the 

NRSRO has appropriately addressed the staffs finding and associated recommendation and has 

implemented its response. Where appropriate, OCR staff also may provide guidance to clarify a 

particular rule or to promote consistency across NRSROs in rule interpretation and application. 

Questions for Mark Flannery, Division of Economic and Risk Analysis: 

l. Dr. Flannery, the President signed Executive Order 13579 in 2011, which requires 

independent regulatory agencies to perform an analysis of rules that "may be 

outmoded, ineffective, insufficient, or excessively burdensome, and to modify, 

streamline, expand, or repeal them in accordance with what has been learned." 

[emphasis added] Has DERA participated or assisted the SEC in this required 

analysis? 

a. Has DERA developed any recommendations for a set of rules that are 

outmoded or excessively burdensome and therefore should be amended? 

5 Id at 103-l 04. 

'Id at 105-106. 

5 
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Response: 

Executive Order 13579 7 states that "independent regulatory agencies should consider 

how best to promote retrospective analysis of rules that may be outmoded, ineffective, 

insufficient, or excessively burdensome, and to modify, streamline, expand, or repeal them in 

accordance with what has been learned." 

The Commission has in place formal and informal processes for the review of existing 

rules to assess the rules' continued utility and effectiveness in light of evolution in the securities 

markets and changes in the securities laws and regulatory priorities, and DERA is an integral 

participant in many of these processes. Specifically: 

• The Commission and staff review existing regulations retrospectively as part of an 

ongoing assessment of substantive program areas. For example, the Commission 

recently proposed a rule pursuant to the Disclosure Effectiveness Initiative and the 

FAST Act to address Commission disclosure requirements that may have become 

redundant, duplicative, overlapping, outdated, or superseded. 

• The Commission reviews its rules pursuant to its obligations under the Regulatory 

Flexibility Act, with a view to identifYing rules in need of modification or rescission. 

• The Commission and staff frequently receive and consider suggestions to review 

existing rules through various types of communications from a wide variety of 

constituencies. 

• The Commission and staff frequently discuss the need to revisit existing rules through 

formal and informal public engagement, including advisory committees, roundtables, 

town hall meetings, speeches, conferences, and other meetings. 

• Commission staff may identifY existing regulations that may merit review through its 

compliance inspection and examination functions, enforcement investigations, and 

the receipt of requests for exemptive relief or Commission or staff guidance. 

In considering changes to existing rules for other reasons (e.g., congressional 

mandates), Commission staff routinely consider related existing rules and assess 

whether to recommend changes to, or the elimination of, those existing rules. 

The Commission has also committed in several recent rules (e.g., Regulation A+, 

crowdfunding, risk retention, and money market fund reform) to specified ongoing review of the 

effects of the rule by staff. Such data-driven analyses can assist the Commission as it monitors 

the market effects of its regulations, as well as any consideration of subsequent rule changes. 

2. Dr. Flannery, last summer, Chair White stated in a speech that she was directing 

the staff to develop recommendations regarding universal proxy. This is obviously a 

controversial topic, where many feel that the costs associated do not outweigh the 

proposed benefits. At what point in time are you or your staff brought in to assist in 

the development of recommendations to assess costs and benefits? 

7 Exec. Order No. 13579, "Regulation and Independent Regulatory Agencies," 76 Federal Register4l587 (July 14, 

2011). 

6 
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24068.063

a. Have you started such an analysis regarding universal proxy? 

Response: 

Economic analysis is a fully-integrated part of the SEC's regulatory process. Per the 

2012 Current Guidance on Economic Analysis in SEC Rulemakings, DERA economists are 

involved at the earliest stages of a rulemaking process, before the specific preferred regulatory 

course is detennined, and throughout the course of writing proposed and final rules. 

On October 26, 2016, the Commission voted to propose two amendments to the proxy 

rules. 8 The proposal issued by the Commission included a robust economic analysis, including 

consideration of the costs and benefits of the proposed rule changes. 

3. Dr. Flannery, the Committee is very concerned with the increasing influence by 

international groups and organizations on the SEC's rulemaking. It comes as no 

surprise to us anymore, that once the FSB issues a report, the FSOC shortly follows 

suit thereafter. 

Response: 

a. In particular, we are concerned about the FSOC's review of asset managers 

as systemically important in light of the Office of Financial Research's 2013 

extremely flawed and inaccurate report. According to Secretary Lew, the 

FSOC has coordinated with the SEC staff in the course of its review of 

"potential risks from asset management products and activities." Has DERA 

been involved or provided comment to the FSOC? 

i. Do you think it is appropriate that the FSOC has decided to review 

activities and products in the asset management industry for systemic 

risk? In your opinion, why do you believe FSOC has shifted its focus 

from asset manager firms to products and activities? 

ii. As you are aware, Chair White has set forth an agenda to enhance the 

oversight of asset managers, ami a number of these rules have been 

proposed. Are you concerned that the separate review of the FSOC 

on the asset management industry could influence what should be a 

data driven rulemaking at the SEC? 

Chair White is a member ofF SOC, and DERA's primary role with respect to FSOC is to 

support the Chair in that capacity. DERA staff also participates in FSOC committees and 

working groups, and we provide FSOC with technical assistance and data if requested by FSOC. 

The oversight of registered funds and the investment advisers that manage them is an 

important function of the Commission. The FSOC is charged with identifying risks to the 

8 See Release No. 34-79164, Universal Proxy (October 26, 2016), available at 

https://www .sec. gov/rules/proposed/20 16/34-79164 .pdf 

7 
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24068.064

financial system of the United States. In its most recent update on the status of its review of 

asset management products and activities, the FSOC focused on potential risks that the asset 

management industry could pose- liquidity risks (liquidity transformation and the first-mover 

advantage), leverage risks, operational risk, securities lending risk, and resolvability and 

transition planning. The SEC's asset management initiatives, announced by Chair White in 

December 2014, are designed to modernize the SEC's regulation of the asset management 

industry, and these projects address many of the potential risks in the registered fund space cited 

in the FSOC's most recent report. 

SEC staff is working to complete the rulemaking projects that are part of the asset 

management initiatives. As illustrated by the Commission's final rule on money market funds, 

the Commission, as an independent regulatory agency, is committed to bringing its own 

expertise to bear in crafting rules through a robust notice and comment rulemaking process, 

pursuant to its statutory mandate to protect investors and to promote efficiency, competition, and 

capital formation. 

Questions for Sean McKessy- Office of the Whistleblower 

I. How do you believe you, and the SEC, can balance the conflicting policy interests of 

wanting whistleblowers to come forward to the SEC, but also encourage employees 

to raise the issue internally to hopefully have the company address it as soon as 

possible? 

Response9

: 

In adopting its whistleblower rules, the Commission recognized that whistleblower 

reporting through internal compliance procedures can complement or otherwise appreciably 

enhance the Commission's enforcement efforts in appropriate circumstances. 1

° For this reason, 

the Commission adopted strong incentives and protections for employees who choose to work 

within their company's own compliance structure because they believe that the employer's 

internal compliance function is an effective mechanism to address any potential wrongdoing. 

For example, under the Commission's whistleblower rules, if an employee reports 

wrongdoing through his or her company's internal whistleblower, legal, or compliance 

procedures, and within 120 days, submits the same information to the Commission, then the 

Commission will consider that the employee provided the information as of the date of his or her 

original report through the company's internal reporting system. 11 This mechanism gives the 

9 Mr. Sean McKessy prepared the below responses before his departure from the Commission on or about July 29, 

2016. 

10 See Release No. 34-64545 at 229, n.450 (May 25, 2011), Implementation of the Whistleblower Provisions of 

Section 21 F of the Securities Exchange Act of /934. ("Whistleblower Adopting Release"), available at 

https://www.sec.gov/rules/final/20 ll/34-64545.pdf 

11 17 C.F.R. § 240.21F-4(b)(7X20l5). 

8 
110 


24068.065

company the opportunity to address misconduct first, while protecting the whistleblower's ''place 

in line" in award consideration in the event that other whistleblowers also report to the 

Commission. Further, the employee's internal report may itselfbeeome award-eligible if the 

company later provides the Commission with the information that the employee reported 

internally, or with the results of an internal investigation that was prompted by the employee's 

report, and the Commission brings a successful enforcement action based on that information. 12 

The Commission's whistleblower rules also support internal reporting through 

consideration of the amount of an award. Section 2IF of the Exchange Act permits the 

Commission discretion to set awards between 10 percent and 30 percent of the amounts collected 

in an enforcement action or related action. 13 The whistleblower rules set forth several factors 

that the Commission will consider in detennining a whistleblower's award percentage, two of 

which relate to the individual's conduct with respect to his or her company's internal reporting or 

compliance system. If the individual reported the violation internally through the company's 

internal reporting channels or mechanisms, then the award percentage may be increased. On the 

other hand, if the individual did anything to interfere with or undermine the company's internal 

reporting process, then his or her award percentage may be decreased. 14 

Employees are more likely to report wrongdoing internally when they believe they will 

not suffer negative consequences for doing so. Thus, along with financial awards, antiretaliation protection is a principle component of the whistleblower incentive structure that 

Congress enacted in Section 21 F of the Exchange Act. 15 The Commission's whistleblower rules 

ensure that employees who choose to report concerns internally receive the same anti-retaliation 

protections under Section 21F as whistleblowers who report to the Commission, irrespective of 

whether they satisfy the criteria to qualify for a whistleblower award. 16 The Commission has 

appeared as amicus in federal courts throughout the country in support of its position that 

internal whistle blowers are entitled to the protection against retaliation under section 21 F of the 

Exchange Act. 17 

a. Do you believe there is a potential conflict of interest for some employees to 

hold off on reporting a tip- either internally or to the SEC- to allow the 

12 17 C.F.R § 240.21F-4(c) (3) (the employee must submit the information they reported internally to the 

Commission within 120 days of providing it to the entity in order to be entitled to this incentive). 

13 15 u.s.c. § 780-6 (b)(!). 

14 17 C.F.R. § 240.21F-6(a) (4); 21F-6 (3). 

15 15 U.S.C. § 78u-6 (h) (1). 

16 17 C.F.R. § 240.21F-2 (b). 

17 See e.g., Berman v. Neo@Ogilvy LLC, 801 F.3d 145 (2d. Cir. 2015). 

9 
111 


24068.066

misconduct to occur longer and potentially increase an SEC settlement, and 

therefore receive a higher award? 

Response: 

The SEC's whistleblower rules were designed to incentivize individuals with knowledge 

of potential securities law violations to report their information promptly. One of the factors the 

Commission considers in determining whether to decrease the award percentage is whether the 

individual unreasonably delayed in reporting the violation. 18 The Commission recently rejected 

a whistleblower's request for a higher award because, although the whistleblower's delay was 

limited in duration, the violations continued and the respondents in the underlying action 

obtained additional ill-gotten gains, with a resulting increase in the monetary sanctions upon 

which the whistleblower's award was based. 19 The Commission reasoned that "it would 

undermine our objective of leveraging whistleblower tips to help detect fraud early and thereby 

protect investor harm if whistleblowers could unreasonably delay reporting and receive greater 

awards due to the continued accrual of wrongful profits." 20 Because the Commission considers 

unreasonable reporting delay in determining award percentage, we believe that whistleblowers 

are incented to report promptly without delay. 

Additionally, a whistleblower could run the risk of losing out on any award if he or she 

delays reporting. For example, under the Commission's rules, an individual who sits on 

knowledge of a fraud until being contacted by investigators generally will not qualify for an 

award. 21 This approach to the statute's requirement that a whistleblower act "voluntarily" was 

intended to create a strong incentive for whistleblowers to come forward early with information 

about possible securities violations. 22 Our rules generally require that, in order to qualify for an 

award, a whistleblower's tip must cause the Commission staff to open an investigation or must 

significantly contribute to the successful action. A whistleblower who waits to report an ongoing 

violation runs the risk that a co-worker or other source might report the wrongdoing first, making 

it so that he or she would have the higher hurdle of providing information that significantly 

contributed to an ongoing investigation. A potential whistleblower who delays in reporting also 

faces the possibility that his or her information will not be "original," and thus not eligible for an 

award, if the agency already learned of the infonnation from another source or through its own 

investigative processes. Accordingly, we believe our rules provide the right checks and balances 

to encourage whistleblowers to come forward as promptly as possible to both preserve their 

18 17 C.P.R.§ 240.21F-6(b)(2)(2015). 

19 See In the Matter o{the Claim Award, Securities Exchange Act, Rel. No. 76338, File No. 2016-I (Nov. 4, 2015). 

20 Id at 3. 

21 17 C.P.R.§ 240.21F-4(a). 

22 Whistleblower Adopting Release at 25. 

10 
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24068.067

eligibility for an award and avoid a potentially significant downward adjustment to their award 

percentage. 

Questions for Mark Wyatt- Office of Compliance, Inspections, and Examinations: 

1. The Dodd-Frank Act subjected thousands of advisers to private funds to SEC 

registration and reporting requirements and therefore examination by OCIE. How 

has this mandate affected the percentage of investment advisers that OCIE is able to 

examine annually? 

Response: 

In general, when OCIE receives mandates to examine new or expanded registrant 

populations, without receiving additional resources, OCfE fulfills its new or expanded 

obligations by drawing resources from other programs. 

In the case of private fund advisers, to enhance industry and product expertise, OCIE has 

formed a small Private Funds Unit. The percentage of staff resources dedicated to the Private 

Funds Unit is disproportionately less than the percentage of advisers registered with the SEC that 

manage private funds (approximately 37 percent of all SEC-registered advisers). 

Since OCTE began examining private fund advisers following the implementation of the 

Dodd-Frank Act, OClE's exams of private fund advisers have yielded tens of millions of dollars 

in recoveries for investors, primarily relating to hidden fees and expense issues. The staff's work 

related to private funds has been a catalyst for the investors in such funds to demand greater 

transparency from the funds' advisers, which, in tum, could benefit retail pensioners whose 

pension plans have invested in private equity funds. 

Response: 

a. As you know, many of these private funds only allow investments from 

accredited investors and qualified institutional buyers. Do these investors 

need the same type of protection as retail investors? How is OCIE's 

examination program tailored to those distinctions? 

OCIE's Private Funds Unit executes private fund adviser exams, builds private fund 

expertise among examiners, and develops new private fund exam approaches. In addition, the 

Private Funds Unit members provide guidance and assistance to other examination teams as 

needed when they encounter issues related to private funds. 

The types of issues identified during exams of private fund advisers may be difficult to 

detect by even the most sophisticated investors. For example, one of the primary issues OClE 

has observed in examinations of private fund advisers is potential misallocation of fees and 

expenses. These include instances in which examiners have observed private fund advisers 

shifting expenses away from the adviser and to the funds' investors or portfolio companies. 

They also include instances in which examiners have observed private fund advisers charging 

II 
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24068.068

fees to the portfolio companies or the funds they manage. These expense allocations and fees 

may not be disclosed to investors in a clear or meaningful manner. Accordingly, these types of 

issues are likely to be a focus during OCIE examinations. 

Moreover, OCIE's private fund exams have enabled Commission staff to better 

understand and take into account private fund business models and the needs of private fund 

investors. The information obtained in OCIE's private fund examinations has assisted 

Commission staff in providing to private fund advisers guidance regarding the application of the 

Investment Advisers Act of 1940 (Advisers Act) and its rules over the past few years. This 

review of the application of the Advisers Act to private fund advisers is ongoing and 

Commission staff may, where appropriate, issue additional guidance. 

Response: 

b. Do you believe OCIE should focus its resources on examining investment 

advisers serving retail customers? If not, how is this practice consistent with 

OCIE's Examination Priorities for 2016 which lists as its top priority 

"Protecting Retail Investors and Investors Saving for Retirement?" 

As stated in OCJE's 2016 Examination Priorities, protecting retail investors and 

retirement savers is an exam priority, and it will likely continue to be a focus for the foreseeable 

future. The 2016 Examination Priorities also stated that OCIE staff will continue examining 

private fund advisers, maintaining a focus on fees and expenses. 23 

Pension plans (private and public), which are large investors in private funds, have been 

harmed by the issues involving private fund advisers' expense allocation and fees discussed 

above. While pension plans are accredited investors, harm to pension plans impact retail 

investors like retired teachers, firefighters, etc. who often rely on the funds as a primary source 

of retirement income. 

2. Mr. Wyatt, the SEC must be a responsible steward of sensitive and proprietary 

information it collects from registered entities, particularly since the Dodd-Frank 

Act has required for the first time registration of advisers to certain private funds. 

Response: 

a. Please outline the top-level framework that the SEC uses to safeguard 

proprietary information collected through Form PF or other means from 

registrants. 

The Commission is committed to protecting proprietary information collected through 

Form PF and other means from registrants. The Dodd-Frank Act provides specific 

confidentiality protections for proprietary infonnation of private fund investment advisers 

collected by the Commission on Form PF. Consistent with the enhanced confidentiality 

23 As noted in OCIE's 2016 Examination Priorities, the priorities mentioned therein do not constitute an exhaustive 

list ofOCIE's initiatives and priorities may change. 

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provisions established under the Dodd-Frank Act, Commission staff has designed and 

implemented controls and systems for the handling of Form PF data across the agency. Senior 

staff members from various Divisions and Offices within the Commission are members of a 

Steering Committee that is tasked with developing and overseeing a consistent and agency-wide 

approach to accessing, sharing, and securing Form PF data. Internal requests to access Form PF 

data arc managed by a centralized access management capability. 

Concerning other information that is collected to support our regulatory mission, the SEC 

adheres to the risk management framework developed by the National Institute of Standards and 

Technology (NIST) that focuses on implementing management, operational and technical 

security controls to protect information stored, transmitted, and processed by agency information 

systems. Identified security requirements are independently validated as part of the SEC's 

Security Assessment and Authorization program and tested periodically to ensure controls are in 

place and operating as intended. Specific controls that are implemented that directly support 

security in field or exam settings include data encryption of information both in transit and at 

rest, secure email protocols, multi-factor authentication, and security awareness and training 

conducted on a regular basis to teach and reinforce all employees and contractors how to protect 

sensitive information. 

Chairman Scott Garrett 

Additional Question for the Record 

Capital Markets Subcommittee Hearing Entitled "Continued Oversight of the SEC's 

Offices and Divisions" 

April21, 2016 

Additional Question for Thomas Butler, Office of Credit Ratings: 

Mr. Butler, your written testimony noted that the "NRSROs have been generally 

responsive to the Commission staffs findings and recommendations." How has regulatory 

oversight of the NRSROs changed since the creation of your office? 

Response: 

a. Alternative: Mr. Butler, over the course of your tenure as Director of this 

office, can you please tell us what changes you have noticed related to the 

regulatory oversight of the NRSROs? For example, since you first submitted 

the Annual report to Congress in 2012 and your most recent report 

submitted to us? 

The Office of Credit Ratings ("OCR") was established in June 20!2, pursuant to the 

Dodd-Frank Act. To date, there have been five public reports issued on the essential findings of 

the annual NRSRO examinations pursuant to the Dodd-Frank Act, four of which were completed 

after the formation of OCR. 24 OCR continues to observe that the examinations are driving 

24 https://www .sec.gov/ocr/reportspubs/special-studieslnrsro-summary-report -2015. pdf; 

https:/ /www .sec.gov/ocr/reportspubs/special-studies/nrsro-summary-report-20 14.mlf; 

https://www .sec.gov/news/studies/20 13/nrsro-sum mary-report-20 13 .pdf; 

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compliance and serving as an effective catalyst for change. fn OCR staffs view, the NRSROs 

have enhanced their understanding of their obligations as regulated entities and they are better 

managed organizations today due to the regulatory requirements and the examinations together 

with their associated recommendations. Many of the NRSROs have hired key personnel, 

restructured their organizations and invested in technology to enhance governance and controls. 

There is also increased disclosure and transparency for the benefit of investors. At several of the 

firms, operational improvements made in prior years are being further integrated and 

strengthened, including investments in compliance systems and infrastructure, and more robust 

procedures and controls for certain ratings processes. 

While there have been significant improvements in the overall compliance cultures at the 

firms, there is always more work to be done. OCR continues to observe examination findings in 

part because the staff conducts disciplined, individualized risk assessments to identify different 

risks for each NRSRO as a component to the examination preparation. For example, during a 

particular examination, OCR may focus on risk-targeted areas such as quantitative analysis and 

information technology, including cybersecurity. As a result, the examination of each NRSRO 

covers all of the eight review areas required by the Dodd-Frank Act while being tailored to the 

NRSRO's specific risk profile to determine areas of emphasis and issues of focus. This bespoke 

approach serves to prevent the examinations from becoming stale and predictable, and assures 

that the examination results represent meaningful improvements to mitigate identified risk areas. 

During recent examinations, OCR has found limited instances where certain NRSROs 

failed to adhere to their policies and procedures related to methodologies, criteria, quantitative 

models and rating publications. OCR has also found limited instances where certain NRSROs 

did not adhere to their IT policies and procedures concerning access, updates and use of thirdparty vendors. The annual examinations include a review of whether the NRSROs appropriately 

addressed the staffs recommendations regarding these findings. Notably, past NRSRO 

examinations have led to referrals to the Division of Enforcement resulting in settled 

administrative proceedings and accompanied by admissions and agreed undertakings together 

with the imposition of fines, disgorgement penalties, prohibitions and industry bars. 

The rules that were adopted by the Commission in August 2014 became effective by June 

20 IS and added substantial new requirements on NRSROs to, among other things, address 

internal controls, manage conflicts of interest and enhance the integrity of the ratings process. 

The annual examinations include an assessment of compliance with these rules. The NRSRO 

must have standards of training, experience and competence for its analysts, which must be 

reasonably designed to ensure that the NRSRO produces accurate credit ratings. 

Global oversight of credit rating agencies has also been strengthened, as jurisdictions 

around the world are adding new and amending existing regulatory requirements. OCR engages 

in bilateral and multilateral dialogue with international credit rating agency regulators to discuss 

examination findings and recommendations and consider risk areas to inform potential future 

examinations. 

https://www .sec.gov/news/studies/20 12/nrsro-summary-report-20 12.pdf; and 

https:/lwww.sec.gov/news/studies/20 11/2011 nrsro section 15e examinations summary report. pdf. 

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In addition to the annual report on NRSRO examinations that is made available to the 

public pursuant to the Dodd-Frank Act, OCR prepares an annual report to Congress on NRSROs 

as required by the Credit Rating Agency Reform Act of 2006. The most recent annual report, 

which was issued in December 2015, discusses the significant competitive inroads that some of 

the smaller NRSROs have made in rating certain asset classes, including commercial mortgagebacked securities. 25 

25 https://www .sec.gov/ocr/reportspubs/annual-reports/20 15.-annual-report -on-nrsros.pdf. 

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The Honorable Luke Messer 

Subcommittee on Capital Markets and Government Sponsored Enterprises Hearing 

Entitled "Continued Oversight of the SEC's Offices and Divisions" 

April21, 2016 

Questions for the Record for Mr. Mark Flannery: 

Mr. Flannery, as I'm sure you're all aware, the Department of Labor recently finalized a 

new and complicated rule imposing fiduciary obligations on certain persons selling 

retirement assets. Despite claims from Secretary Perez that DOL "worked extensively" 

with the SEC throughout the rulemaking process, actual comments from SEC officials and 

staff suggest otherwise. In fact, former SEC Commissioner Gallagher criticized the DOL 

rule comment period, calling it "merely perfunctory." However, Commissioner Gallagher 

made these comments well before the DOL issued its final rule. 

Mr. Flannery, did the Department of Labor change their approach in their collaboration 

with the SEC before issuing their final rule-were these collaborations more than "merely 

perfunctory"? 

As a result of these collaborations, did the DOL amend the rule to account for concerns 

raised by SEC officials and staff? 

Has DERA undertaken an analysis of the impact of the DOL rule? 

If not, how would DERA analyze the potential adverse effects of adviser conflict of 

interest? 

Is it even possible to analyze the cost of this kind of conflict of interest with a reasonable 

level of statistical certainty? 

Mr. Flannery, in an email uncovered in a report issued by the Senate Homeland Security 

and Governmental Affairs Committee, an SEC economist responded to an email from a 

DOL economist stating "I am now utterly confused as to what the purpose ofthe proposed 

DOL rule is then, if not to limit advisor conflicts when providing retirement advice?" 

Mr. Flannery, do you believe the final DOL fiduciary rule will reduce advisor conflict of 

interest? What types of individuals arc likely to lose access to their financial advisers as a 

result of the rule? 

Response: 

As separate agencies, with distinct regulatory mandates, the Commission and the DOL 

may each proceed independently to consider changes to the standards that apply to advice given 

by each of our regulated entities. However, in light of potential impacts that rulemaking may 

have on regulated entities, investors, and the markets, consultation between the DOL and the 

SEC has been, and will continue to be, important. 
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SEC staff, including DERA staff, provided DOL staff technical assistance and expertise 

on the Commission's regulatory regime as DOL considered its rule. SEC staff also shared 

experiences with how services are provided in this area of the market. Given DOL's 

independent statutory authority in this area, however, we gave our comments with the 

understanding that the DOL may accept or challenge our views as it saw fit. 

We will of course perform a thorough economic analysis, compliant with the Current 

Guidance on Economic Analysis in SEC Rulemaking, of any uniform fiduciary rule that the 

Commission issues, and will issue that economic analysis for comment in conjunction with the 

proposed rules: I expect that the DOL's rule, including the DOL's regulatory impact analysis 

that accompanied the rule, will be important for DERA to review and analyze as part of the 

regulatory baseline our explanation of the existing state of the world that is an integral part 

of each of our economic analyses. 

Given the current status of that project, which is a challenging one it is a complicated 

issue with potentially direct impacts on millions of investors and given the independent 

jurisdiction of the DOL, I have not had the opportunity to study or form an opinion on the likely 

effects of the DOL rule on broker or adviser conflicts of interest or access to brokers or advisers, 

or whether any such effects have already begun to manifest themselves in the marketplace. 

Questions for the Record for Mr. Marc Wyatt: 

Mr. Wyatt, as you're well aware, Dodd-Frank gave the SEC new authorities to pursue 

certain cases through administrative proceedings, rather than filing in a Federal Court. 

This broke long standing precedent that dates back to the inception of the agency. 

According to the Wall Street Journal, the SEC has a distinct advantage when pursuing 

cases through administrative proceedings-when they are "operating on their own turf'-

winning over 90% of cases, while only winning 69% of cases iu Federal court. Stanley 

Sporkin, a former SEC enforcement chief, said it might appropriate to address the 

"perception problem" the SEC in-house court has by amending the law. 

Do you agree with Mr. Sporkin'? Do you support legislation, like Chair Garrett's bi11 1

, that 

would protect the right to due process? 

Response: 

Given that OCIE is responsible for administering the SEC's nationwide examination and 

inspection program. OCIE does not bring enforcement actions or initiate any administrative 

proceedings. As such, I am not in a position to express a view regarding Mr. Sporkin's statement 

or any related legislation. 

Mr. Wyatt, according to the SEC FY 2017 Congressional Budget Justification, 

approximately 31% of examinations conducted by OCIE in 2015 resulted in a "significant 

'Due Process Act of2015. H.R. 3789. 114'" Cong. (]" Sess., 2016) 

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finding," which by your definition means deficiencies in firm operations having a high 

potential to cause harm to clients of a firm, or reflect recidivist misconduct. 

Mr. Wyatt, given this high number of "significant findings" as a result of these 

examinations, why have SEC exam rates remained constant, as a percentage of the 

industry, when the SEC receives regular increases in its annual appropriations and has a 

Reserve Fund outside of the appropriations process from which the SEC can spend up to 

$50 million each year without limitation? 

Response: 

Over the past several years, OCIE has improved efficiencies by refining its risk-based 

approach to selecting and examining firms and conducting more narrowly-focused examinations 

that concentrate on specific issues and areas of industry risk. These efforts have contributed to 

recent increases in the number of examinations completed, as OCTE completed more exams in 

FY20 16 than in any of the prior seven years. During the same time, OCIE has continued a 

number of critical staff activities that are not reflected in our examination (and corresponding 

coverage) numbers, including conducting hundreds of outreach and education programs and 

thousands of internal desk reviews. 

It is also important to note that the number of registrants examined and overall 

examination rates are dependent on many factors, including the types and scope of examinations 

conducted in each year, the size and complexity of firms examined, program priorities, 

legislative changes, changes in registrant populations, and, of course, staffing levels. For 

example, the number of registered advisers, their complexity, and their assets under management 

has increased substantially over the last decade, making it increasingly difficult to materially 

improve coverage levels with existing resources. Given this growth, effective October 1, 2016, 

OCIE has transitioned some staff from our broker-dealer examination program to the investment 

adviser/investment company examination program, with the goal of increasing our coverage of 

investment advisers. We will keep examining broker-dealers and maintain a significant presence 

nationwide, including in market centers such as New York and Chicago. We will also bolster 

our oversight ofFINRA and are exploring ways to leverage FINRA's resources and its 

regulatory reach into the broker-dealer industry. We believe that this pro-active approach will 

likely improve coverage even further in the areas of greatest risk to investors. Finally, OCIE has 

made significant improvements in productivity and capability through technology advancements 

over the past several years, benefitting from a portion of the resources provided by the SEC's 

technology reserve fund. 

Could you please explain how the employee's union collective bargaining agreement with 

the SEC impacts the Office's ability to increase its annual examinations rates? 

Response: 

We have a strong working relationship with the National Treasury Employees Union. 

While there is naturally some compromise through negotiation in any labor-management forum, 

particularly in the work-life areas included in the collective bargaining unit, we believe it to be 

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offset by improvements in staff morale, job satisfaction, productivity, and attracting new talent, 

as supported by OCIE's 2015 Federal Employee Viewpoint Survey and examination results, 

among other things. For example, 94.9% of OCIE staff responded that they would put in the 

extra effort to get a job done when needed. Moreover, 88.7% of OCIE staff felt that the work 

they did was important, and 83.6% of the staff responded that they felt that their supervisor 

supported their need to balance work and other life issues. At the same time, OCIE's total 

number of completed examinations has increased progressively each of the past five years. Also, 

as you noted, the significant findings resulting from examinations is approximately 31%, which 

we believe is one indicator that our examinations are effective. Overall, we believe we 

successfully manage an effective and efficient examination program in the given environment. 

What steps would need to be taken to increase the amount of examinations each examiner 

conducts per year? 

Response: 

The number and type of entities over which OCIE has examination authority has 

expanded considerably over the past several years and placed a greater demand on OCIE's 

resources. With this increased responsibility, OCIE has recognized the importance of 

maximizing the efficiency and effectiveness with which it utilizes those resources in carrying out 

its work. OCIE has made it a priority to channel its limited resources toward their highest and 

best use by implementing a risk-based strategy across the entire examination program. OCIE has 

taken, and will continue to pursue, several steps to maximize its limited resources for overseeing 

regulated entities. These include continuing to refine the program's risk assessment process and 

use of focused initiatives, leveraging technology and data analytics in examination planning and 

execution, recruiting industry experts, and strengthening examiner training. 

Finally, it is important to emphasize that the quality of exams we are conducting is our 

main priority. Increases or decreases in exam numbers do not tell the entire story of our program 

as exam numbers alone do not speak to quality or the breadth of our work. 

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4/21/2016 Hearing 

Subcommittee on Capital Markets & Government Sponsored Enterprises 

"Continued Oversight of the SEC's Offices and Divisions" 

Questions for Mr. Flannery from Rep. Neugebauer: 

Are you concerned that the proposed rule 18f-4, use of derivatives by Registered 

Investment Companies, will limit the average investor's ability to access diversifying 

assets? Are you concerned that this rule could harm rather than protect investors as it 

limits diversity and makes for a higher concentration of riskier investments like equities? 

Response: 

Currently. registered funds can create significant leverage through derivatives, which 

could expose investors to the risk of considerable losses. Further, certain derivatives that achieve 

similar economic exposures are, under the current regulatory framework, treated differently, 

which can create economic inefficiencies. The Commission's proposed rule regarding 

derivatives would limit certain leveraged exposures, require that funds operate with an adequate 

buffer to meet their derivatives obligations, and focus the attention of fund managers and boards 

on ensuring that derivatives risks are properly managed. 

The economic analysis included in the release sets out the proposed rule's potential 

economic impacts, including both the benefits and costs. The proposed rule could benefit 

investors by limiting the possibility that they would suffer outsized losses caused by using 

derivatives to achieve leverage, and it could benefit funds through a consistent and 

comprehensive yet flexible treatment of derivatives. Our economic analysis also acknowledged 

potential costs. While many funds do not use derivatives in substantial amounts and would not 

be significantly affected by the rule, other funds could react in a number of ways, including by 

shifting their portfolio composition or investment strategy, or operating in a legal structure that is 

not subject to the limitations on leverage that the proposed rule would apply. The release 

acknowledges that there is significant uncertainty as to which of these various options funds are 

likely to pursue, but that they could have impacts on investors. The Commission staff is actively 

considering comments received on the proposed rule. 

Proposed rule 18f-4, use of derivatives by Registered Investment Companies, attempts to 

regulate the use of derivatives but will ultimately alter the commodities futures market by 

setting arbitrary portfolio limitations for derivatives. The rule incentivizes funds to 

overweight portfolios with stocks and bonds and move away from trading commodities. 

What is your view on the regulation of simple, diversifying derivatives? Can you tell me 

how the SEC intends to fix this problem with the rule? 
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Response: 

One of the difficulties the release acknowledges is that derivatives used for diversifying 

or hedging purposes may sometimes fail to have their anticipated effect. If they fail to perform 

as intended, they may instead result in additional, speculative exposure. Similarly, the release 

noted in conjunction with its proposed exemption for netting purposes, that some seeminglyoffsetting transactions may not have the effect of eliminating or reducing market exposure. For 

example, using a pair of derivatives contracts to produce a "collar" or "spread" return might 

introduce potential risks associated with strategies that seek to capture small changes in the value 

of such paired instruments. 

The DERA staff white paper on the use of derivatives in mutual funds released in 

conjunction with the proposed rule last December finds that certain funds that invest in 

commodity derivatives are among the more intensive users of derivatives. However, the 

Commission observed in the proposing release that the Commission staffs analysis indicated 

that it should be possible for funds to pursue, in some form, almost all existing types of 

investment strategies in compliance with the proposed rule. The economic analysis included in 

the release discusses the economic effects that could result if funds were to respond to the 

proposed rule by shifting their portfolio composition, including through purchasing substitute 

instruments, or by offering the investment strategy through some other form of investment 

vehicle, such a hedge fund, that would not be subject to the limitations on derivatives discussed 

in the proposed rule. 

The proposed rule was put forth for public comment in December 2015, and the comment 

period closed March 28, 2016. The Commission staff is actively considering comments received 

on the proposed rule. Chair White has indicated that moving forward with this rule is one of her 

rulemaking priorities. 

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