ENHANCING INVESTOR PROTECTION AND THE REGULATION OF 

SECURITIES MARKETS—PART II 

S. HRG. 111–144 

ENHANCING INVESTOR PROTECTION AND THE 

REGULATION OF SECURITIES MARKETS—PART II 

HEARING 

BEFORE THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED ELEVENTH CONGRESS 

FIRST SESSION 

ON 

FURTHER EXAMINING WHAT WENT WRONG IN THE SECURITIES 

MARKETS, HOW WE CAN PREVENT THE PRACTICES THAT LED TO 

OUR FINANCIAL SYSTEM PROBLEMS, AND HOW TO PROTECT 

INVESTORS 

MARCH 26, 2009 

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53–176 PDF 2009

S. HRG. 111–144 

ENHANCING INVESTOR PROTECTION AND THE 

REGULATION OF SECURITIES MARKETS—PART II 

HEARING 

BEFORE THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED ELEVENTH CONGRESS 

FIRST SESSION 

ON 

FURTHER EXAMINING WHAT WENT WRONG IN THE SECURITIES 

MARKETS, HOW WE CAN PREVENT THE PRACTICES THAT LED TO 

OUR FINANCIAL SYSTEM PROBLEMS, AND HOW TO PROTECT 

INVESTORS 

MARCH 26, 2009 

Printed for the use of the Committee on Banking, Housing, and Urban Affairs 

( 

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html 
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

CHRISTOPHER J. DODD, Connecticut, Chairman 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

JON TESTER, Montana 

HERB KOHL, Wisconsin 

MARK R. WARNER, Virginia 

JEFF MERKLEY, Oregon 

MICHAEL F. BENNET, Colorado 

RICHARD C. SHELBY, Alabama 

ROBERT F. BENNETT, Utah 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

MEL MARTINEZ, Florida 

BOB CORKER, Tennessee 

JIM DEMINT, South Carolina 

DAVID VITTER, Louisiana 

MIKE JOHANNS, Nebraska 

KAY BAILEY HUTCHISON, Texas 

COLIN MCGINNIS, Acting Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director 

DEAN SHAHINIAN, Senior Counsel 

JULIE CHON, Senior Policy Adviser 

BRIAN FILIPOWICH, Legislative Assistant 

MARK OESTERLE, Republican Chief Counsel 

HESTER PIERCE, Republican Senior Counsel 

ANDREW OLMEM, Republican Senior Counsel 

DAWN RATLIFF, Chief Clerk 

DEVIN HARTLEY, Hearing Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

(II)
C O N T E N T S 

THURSDAY, MARCH 26, 2009 

Page 

Opening statement of Chairman Dodd .................................................................. 1 

Opening statements, comments, or prepared statements of: 

Senator Shelby .................................................................................................. 4 

WITNESSES 

Mary L. Schapiro, Chairman, Securities and Exchange Commission ................. 5 

Prepared statement .......................................................................................... 74 

Response to written questions of: 

Senator Menendez ..................................................................................... 247 

Fred J. Joseph, President, North American Securities Administrators 

Association ............................................................................................................ 7 

Prepared statement .......................................................................................... 84 

Richard C. Breeden, Former Chairman, Securities and Exchange Commission 33 

Prepared statement .......................................................................................... 92 

Arthur Levitt, Former Chairman, Securities and Exchange Commission .......... 34 

Prepared statement .......................................................................................... 101 

Paul S. Atkins, Former Commissioner, Securities and Exchange Commission . 37 

Prepared statement .......................................................................................... 104 

Richard G. Ketchum, Chairman and Chief Executive Officer, Financial Industry Regulatory Association .................................................................................. 53 

Prepared statement .......................................................................................... 162 

Ronald A. Stack, Chair, Municipal Securities Rulemaking Board ...................... 55 

Prepared statement .......................................................................................... 166 

Richard Baker, President and Chief Executive Officer, Managed Funds 

Association ............................................................................................................ 57 

Prepared statement .......................................................................................... 181 

Response to written questions of: 

Senator Reed .............................................................................................. 249 

James Chanos, Chairman, Coalition of Private Investment Companies ............ 59 

Prepared statement .......................................................................................... 187 

Response to written questions of: 

Senator Reed .............................................................................................. 254 

Barbara Roper, Director of Investor Protection, Consumer Federation of 

America ................................................................................................................. 61 

Prepared statement .......................................................................................... 195 

David G. Tittsworth, Executive Director and Executive Vice President, Investment Adviser Association .................................................................................... 62 

Prepared statement .......................................................................................... 216 

Rita M. Bolger, Senior Vice President and Associate General Counsel, Global 

Regulatory Affairs, Standard & Poor’s ............................................................... 64 

Prepared statement .......................................................................................... 228 

Response to written questions of: 

Senator Reed .............................................................................................. 277 

Daniel Curry, President, DBRS, Inc. ..................................................................... 66 

Prepared statement .......................................................................................... 243 

Response to written questions of: 

Senator Reed .............................................................................................. 277 

(III)

(1) 

ENHANCING INVESTOR PROTECTION AND 

THE REGULATION OF SECURITIES MARKETS—PART II 

THURSDAY, MARCH 26, 2009 

U.S. SENATE, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

Washington, DC. 

The Committee met at 9:36 a.m., in room SD–538, Dirksen Senate Office Building, Senator Christopher J. Dodd (Chairman of the 

Committee) presiding. 

OPENING STATEMENT OF CHAIRMAN CHRISTOPHER J. DODD 

Chairman DODD. Good morning. The Committee will come to 

order. Let me welcome my colleagues who are here, as well as our 

witnesses. We have a very busy morning today. We have got a long 

list of very distinguished witnesses to appear before us this morning on the subject matter of enhancing investor protection and the 

regulation of securities markets. This is the ninth—is it the ninth 

or tenth?—on the general matter of the modernization of Federal 

regulations and the second very specific hearing on the securities 

industry itself. 

There is an awful lot of ground to cover here. We have three panels this morning, the first, of course, involving Mary Schapiro, the 

Chairman of the Securities and Exchange Commission, and Fred 

Joseph, who is the President of North American Securities Administrators Association. 

A second panel of witnesses who have been before this Committee on numerous occasions, of course, the previous Chairs—I see 

Mr. Breeden is here already this morning, and Arthur Levitt and 

others, along with Paul Atkins, who will be testifying about their 

experience, background, how this all emerged, and their thoughts 

on how we move forward. 

And then a third panel of witnesses who will give us some very 

current experiences they are going through and ideas and thoughts 

as to how we ought to proceed. So I appreciate their testimony. 

What I am going to do is have opening statements by just Senator Shelby and myself, although Senator Warner is here, and as 

long as no one else shows up, you can make an opening statement, 

because I worry about if we have everybody show up, we will be 

here until midnight tonight. 

[Laughter.] 

Senator SHELBY. Governor Warner—he is used to those opening 

statements. 
2 

Chairman DODD. Yes, I know. Well, he was a good Governor and 

he is a good Senator. We welcome him to this Committee. 

Then I am going to ask my colleagues—we are going to have one 

round on the first panel. As much as there are many questions, obviously, we have for both of you, but if we end up with too many 

rounds, we will never get to the second and third panels, and colleagues have busy schedules as well, as do our witnesses. So we 

will cut it off after one round. 

Then we will go to the second panel, which I will leave a little 

more open, given the backgrounds of our witnesses, and the third 

panel. 

With that, let me share some opening comments and then turn 

to Senator Shelby, and then we will go right to our witnesses this 

morning. 

Today, the Committee meets, as I said, for our second hearing to 

examine the securities market regulation, the ninth hearing on this 

general matter of modernization of Federal regulations. This hearing is to discuss how investors and our entire financial system are 

protected, or lack of protection, in the future from the kind of activities that led to the current crisis. This hearing is one of a series, 

as I mentioned, of nine we have already convened to modernize the 

overall regulatory framework and to rebuild our financial system. 

And I saw this morning the headlines of our local newspaper here, 

the direction that the Secretary of the Treasury is heading. I welcome that. This is all within about 60 days of this administration 

coming to office. We will not have all the time this morning to go 

over that. This Committee will be meeting at the request of the 

Treasury tomorrow with Democrats and Republicans to listen to 

some of these thoughts. It is not a formal hearing. We will have 

one of those. But given the time constraints and the fact that the 

administration is heading overseas to the meeting coming up with 

the G-20, we thought it would be worthwhile to have at least a 

briefing as to where this thing is heading. So we welcome that and 

are excited over the fact that they are going to be proposing some 

thoughts in this area as well. 

We are also very excited to have two witnesses who are not only 

former Chairmen of the SEC but also, I might add, residents of my 

own State as well, having Arthur Levitt and Richard Breeden with 

us. 

From the outset, I have argued that our financial system is not 

really in need of reform but modernization, that truly protecting 

consumers and investors in the decades to come will require a vast 

overhaul of our financial architecture that recognizes the extraordinary transformation that has occurred over the last quarter of a 

century, and it is extraordinary. And nowhere has that transformation been clearer than in the area of securities, which have 

come to dominate our financial system, now representing 80 percent—80 percent—of all financial assets in the United States. 

With pension funds, the proliferation of 401(k)s and the like, 

today half of all households in the United States are invested in 

some way in the securities markets. As Federal Reserve Governor 

Dan Tarullo said at our last hearing on this subject matter, ‘‘The 

source of systemic risk in our financial system has, to some consid-
3 

erable extent, migrated from traditional banking activities to markets over the last 20 or 25 years.’’ 

In essence, as the assets of our financial system have shifted 

from banking deposits to securities, so too have the dangers posed 

to our economy as a whole. We need regulators with the expertise, 

tools, and resources to regulate this new type of financial system. 

At our last hearing on this subject, this Committee heard about 

the need to watch for trends that could threaten the safety of our 

financial system. Our witnesses had different views on what regulatory body should perform that function. Some felt it should be 

given to a special commission made up of the heads of existing 

agencies. Others have argued for a new agency or to give that authority to an existing regulator. 

As I have said, given the regulatory failures we saw in the leadup to this crisis, I have concerns, and I think many of my colleagues have also expressed, about this authority residing exclusively within one body. And I re-express those views this morning. 

For instance, we have seen problems with the regulated bank 

holding companies where they have not been well regulated at the 

holding company level. And while there are many aspects to our financial system, systemic risk itself has many parts as well. One is 

the regulation of practices and products which pose systemic risk, 

from subprime mortgages to credit default swaps, and that is why 

I remain intrigued by the idea of a council approach to address this 

aspect of systemic risk. And I know our previous witnesses Paul 

Stevens with the Investment Company Institute and Damon Silvers with the AFL–CIO have both recommended this type of concept. 

Of course, systemic risk is only one issue which we are examining. At our last hearing on this subject matter, we heard how we 

could increase transparency by addressing the risks posed by derivatives. We heard ways to improve the performance of credit rating agencies, who failed the American people terribly, by requiring 

them to verify the information they used to make those ratings. 

And, more recently, Secretary of Treasury Geithner has proposed 

the creation of a resolution mechanism for systemically important 

nonbank financial institutions, and I will be very interested in 

hearing from you, Chairman Schapiro, on that subject matter, what 

your thoughts are and the role the SEC should play. 

In providing this authority to the FDIC, I am pleased that they 

have recognized the need to ensure that powerful new tools do not 

all reside, again, with any single agency. 

These are all ideas that deserve careful examination, which we 

will engage in here at this Committee. Today’s diverse panel, including representatives from hedge funds, credit rating agencies, 

retail investors, industry self-regulatory organizations, paints a 

very vivid picture of the numerous issues facing the securities markets at this moment. 

The goals of modernization are clear, in my view: consistent regulation across our financial architecture with strong cops on the 

beat in every neighborhood; checks and balances to ensure our regulators and the institutions that oversee them are held accountable; and transparency so that consumers and investors are never 

in the dark about the risks they will be taking on. 
4 

The time has come for a new era of responsibility in financial 

services. That begins with the rebuilding of our 21st century financial architecture from the bottom up, with the consumer clearly in 

our minds in the forefront. It begins with the work of this Committee, and, again, this is now almost the tenth hearing on the subject matter. Senator Shelby and I and our colleagues here are determined to play a constructive and positive role as we help shape 

this debate in the coming weeks. 

With that, let me turn to Senator Shelby. 

STATEMENT OF SENATOR RICHARD C. SHELBY 

Senator SHELBY. Thank you, Mr. Chairman. 

I look forward to hearing from our witnesses today. I am particularly interested in hearing from SEC Chairman Schapiro about the 

steps that she is taking to address the agency’s recent regulatory 

failures. This includes the disappearance of the investment banks, 

the SEC’s largest regulated entities there; the systemically devastating failures by the credit rating agencies that enjoy the SEC’s 

implicit seal of approval; and the Madoff fraud. I believe that 

changes in the way the agency is managed and how its resources 

are used will be of utmost importance in getting the SEC back on 

the right track. 

The insights of former SEC Chairmen and Commissioners, State 

securities regulators, and self-regulatory organizations will also be 

useful in determining what changes may be needed. For that reason, I am pleased that we have representatives of each of these 

groups here today. Only by hearing a wide range of perspectives 

and by digging deep inside these agencies and failed financial institutions will we be able to fully understand how we got into this crisis, how we can get out of it, and how we can prevent them in the 

future. 

Mr. Chairman, I think we are on the right road here breaking 

all this down into the various parts, and I commend you for that. 

Chairman DODD. Thank you very much. 

I only see a couple of our colleagues, and I know that Senator 

Corker likes to give long opening statements. 

[Laughter.] 

Chairman DODD. So I am going to presume we are going to pass 

and get right to our witnesses. All right. Senator Tester, any quick 

comments? 

Senator TESTER. Well, since Senator Corker is here, I want to 

give a long opening statement. 

[Laughter.] 

Senator TESTER. I pass. 

Chairman DODD. Well, again, Chairman Schapiro and Mr. Joseph, we thank you for coming before the Committee, and let me 

just say to my colleagues and witnesses—I always say this, but it 

needs to be said—that any supporting documents and information 

you think would be helpful in expanding your answers to questions 

or comments or full opening statements my colleagues would like 

to make will be included in the record as we go forward. And we 

will leave the record open for several days because invariably there 

will be additional questions I think my colleagues would like to 
5 

ask, and we will leave that record open and ask you to respond as 

quickly as possible. 

With that, Chairman Schapiro, we welcome you before the Committee again. 

STATEMENT OF MARY L. SCHAPIRO, CHAIRMAN, 

SECURITIES AND EXCHANGE COMMISSION 

Ms. SCHAPIRO. Thank you very much, Chairman Dodd, Ranking 

Member Shelby, and Members of the Committee. I appreciate the 

opportunity to testify as we face a critical juncture in the history 

of our Nation’s financial markets. It is a particular pleasure to appear with Fred Joseph, Securities Commissioner from the State of 

Colorado and the head of NASAA. 

I am testifying today on behalf of the Commission as a whole. 

The Commission agrees that our goal is to improve the financial 

regulatory system, that we will work constructively to that end, 

and that we are all fully committed to the mission of the SEC. In 

light of the recent economic events and their impact on the American people, I believe this Committee’s focus on investor protection 

and securities regulation as part of a reconsideration of the financial regulatory regime is timely and critically important. 

I strongly support the view that there is a need for systemwide 

consideration of risks to the financial system and for the creation 

of mechanisms to reduce and avert systemic risks. I am equally 

convinced that regulatory reform must be accomplished without 

compromising the integrity of our capital markets or the protection 

of investors. This is the SEC’s core mission, and we believe that an 

independent agency with this singular focus is an essential element 

of an effective financial regulatory regime. 

I believe that three general principles should feature prominently 

in regulatory reform. The first is that an integrated capital markets regulator that focuses on investor protection is indispensable 

to restoring investor trust and confidence, which is in turn indispensable to the recovery of our economy; second, that regulator 

must be independent; and third, a strong and investor-focused capital markets regulator complements the role of a systemic risk regulator, resulting in a more effective oversight regime. 

The SEC’s regulation of the Nation’s capital markets involves an 

integrated set of functions that promote the efficiency, competition, 

and fairness of our markets for the benefit of investors; through the 

regulation of the exchanges, clearing agencies, and transfer agents 

that provide the infrastructure that makes our markets work at 

lightning speed, with remarkable efficiency, and at low cost to investors; through the provision of accurate, meaningful, and timely 

corporate information which allows investors to allocate capital efficiently; through the independence of expert accounting standard 

setters to ensure that the primary focus in standard setting is investors reading financials, not the companies preparing them; 

through the rules that ensure that mutual and money market 

funds which hold over $9 trillion of assets are operated for the benefit of investors and only investors; through the oversight of 5,500 

broker-dealers and over 11,000 investment advisers to whom investors turn for guidance when accessing our capital markets; and, fi-
6 

nally, through enforcement, done aggressively and without fear or 

favor. 

Each of the SEC’s core functions interacts with the others. As an 

aggregated set, they provide for strong capital markets oversight. 

Take any function away, and the investor protection mission suffers. If the functions are disaggregated, capital markets oversight 

becomes diluted and investors suffer. 

As we look to the future of securities regulation, we believe that 

independence is an essential attribute of a capital market’s regulator. Congress created the SEC to be the investor’s advocate, and 

Congress did so precisely so that we can champion those who otherwise would not have a champion and, when necessary, take on 

the most powerful interests in the country. Regulatory reform must 

guarantee that independence in the future. 

Finally, the SEC, as a strong and independent capital markets 

regulator, will work cooperatively to support the mission of systemic risk regulation, whether it is accomplished through the designation of a single entity to monitor and control risk or through 

a college of regulators approach. 

When I returned to the SEC as Chairman in January, I appreciated the need to act swiftly to help restore investor confidence in 

our markets and in the SEC. In less than 2 months, we have instituted important reforms to reinvigorate our enforcement program, 

better train our examination staff, and improve our handling of 

tips and complaints. To address short selling, the Commission will 

consider proposals early next month to reinstate the uptick rule. 

And on April 15th, the Commission will hold a public roundtable 

on possible credit rating agency reforms. 

This spring, I will ask the Commission to consider proposals to 

strengthen money market funds through improvements to credit 

quality, maturity, and liquidity standards; improve investor access 

to public company proxies; and significantly enhance controls over 

the safekeeping of investor assets. 

But we cannot do everything alone, and this crisis highlights several pressing needs. I expect to ask for the Committee’s help with 

legislation that would require registration of investment advisers 

who advise hedge funds, and likely of the hedge funds themselves; 

legislation to break down statutory barriers between broker-dealers 

and investment advisers, and to fill other gaps in regulatory oversight, including those related to credit default swaps and municipal 

securities, an area that has far too long needed more robust oversight. 

Every day when I go to work, I am committed to putting the SEC 

on track to serve as a forceful regulator for the benefit of America’s 

investors. Today, the SEC’s core mission of capital markets oversight and investor protection is as fundamentally important as it 

ever was, and I am fully committed to ensuring that the SEC carries out that job in the most effective way it can. 

Thank you again for the opportunity to share the SEC’s views. 

We very much look forward to working with the Committee on any 

financial reform efforts in the months ahead, and I, of course, 

would be pleased to answer any questions. 

Chairman DODD. Thank you very much, Chairman Schapiro. 

Mr. Joseph, thank you very much for being with us. 
7 

STATEMENT OF FRED J. JOSEPH, PRESIDENT, NORTH 

AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION 

Mr. JOSEPH. Thank you, Mr. Chairman. Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I am Fred Joseph, Colorado Securities Commissioner and President of the North 

American Securities Administrators Association—NASAA. I am 

honored to be here today to discuss legislative and regulatory 

changes that are most relevant to Main Street Americans who are 

looking to regulators and lawmakers to help them rebuild and safeguard their financial security. 

In November 2008, NASAA released its Core Principles for Regulatory Reform in Financial Services and subsequently issued a proinvestor legislative agenda for the 111th Congress. Today I would 

like to highlight the recommendations that we feel are most vital 

to sound regulatory reform and strong investor protection. 

NASAA’s top legislative priority is to protect investors by preserving State securities regulatory and enforcement authority over 

those who offer investment advice and sell securities to their residents. Just one look at our enforcement data shows the effectiveness of State securities regulation. Last year in Colorado alone, my 

office conducted investigations that led to 246 enforcement actions, 

resulting in $3 million ordered to be returned to investors and 434 

years of prison time for fraudsters. And just last month, a Ponzi 

scheme investigation launched by my office resulted in a prison 

sentence of 132 years for the main perpetrator. 

And yet, over a number of years there have been calls for preemption of State regulation and enforcement. The National Securities Markets Improvement Act of 1996, NSMIA, preempted much 

of the States’ regulatory authority for securities traded in national 

markets. Although it left State antifraud enforcement largely intact, it limited the States’ ability to address fraud in its earliest 

stages before massive losses have been inflicted on investors. 

An example of this is in the area of private offerings under Rule 

506 of Regulation D. These offerings enjoy an exemption from registration under Federal securities law, so they receive virtually no 

regulatory scrutiny. As a result, we have observed a significant rise 

in the number of offerings made pursuant to Rule 506 that are 

later discovered to be fraudulent. 

Although Congress preserved the States’ authority to take enforcement actions for fraud, this power is no substitute for a State’s 

ability to scrutinize the offerings for signs of potential abuse and 

to ensure that disclosure is adequate before harm is done to investors. NASAA believes the time has come for Congress to reinstate 

State regulatory oversight of all Rule 506 offerings. 

Next, the Madoff case illustrates the horrific consequences we 

face when an investment adviser’s illegal activity goes undetected 

and unchecked for an extended period. NASAA recommends two 

changes to enhance the States’ role in policing investment advisers. 

First, the SEC should expand the class of IAs that are subject to 

State registration and oversight. In NSMIA, Congress provided 

that the States would regulate IAs with up to $25 million in assets 

under management, while the SEC would regulate the larger IAs. 

Congress further intended that the SEC would periodically review 

this allocation of authority and adjust it appropriately. The time is 
8 

now for the $25 million ‘‘assets under management’’ test to be increased possibly to $100 million. 

Congress should also consider enhancing the States’ enforcement 

authority over large IAs. Currently, a State can only take enforcement action against a federally registered investment adviser if it 

finds evidence of fraud. This authority should be broadened to encompass any violations under State law, including dishonest and 

unethical practices. This enhancement will not interfere with the 

SEC’s exclusive authority to register and oversee the activities of 

large IAs. 

NASAA also urges Congress to apply the fiduciary duty to all financial professionals who give investment advice regarding securities—broker-dealers and investment advisers alike. This step will 

enhance investor protection, eliminate confusion, and even promote 

regulatory fairness by establishing conduct standards according to 

the nature of the services provided and not the licensing status of 

the provider. 

The fiduciary duty is the obligation to place a client’s interest 

first, to eliminate any conflicts of interest, and to make full and 

fair disclosure to clients. We recommend that Congress ratify the 

highest standard of care. For all financial professionals, the interests of the clients must come first at all times. 

Many observers believe that private actions are the principal 

means of redress for victims of securities fraud, but they also play 

an indispensable role in deterring fraud and complementing the enforcement efforts of Government regulators and prosecutors. The 

problem is that Congress and the U.S. Supreme Court have restricted the ability of private plaintiffs to seek redress in court for 

securities fraud. These restrictions have not only reduced the compensation available to those who have been the victims of securities 

fraud, but they have also weakened a powerful deterrent against 

misconduct in our financial markets. Removing excessive restrictions on access to the courts would not only provide just compensation for investors, it would also benefit regulators by restoring a 

powerful deterrent against fraud and abuse—that is, the threat of 

civil liability. 

In conclusion, State securities regulators believe that enhancing 

our securities laws and regulations and ensuring they are being 

vigorously enforced is the key to restoring investor confidence in 

our markets. NASAA and its members are committed to working 

with the Committee to ensure that the Nation’s financial services 

regulatory regime undergoes the important changes that are necessary to enhance Main Street investor protection, which State securities regulators have provided for nearly 100 years. 

Thank you very much. 

Chairman DODD. Thank you very much, Mr. Joseph. We appreciate that very much. We will begin with the first round, and I will 

ask the clerk to keep an eye on this clock here so we make sure 

we get to everybody and move along with as many witnesses we 

have. 

Madam Chairman, thank you again for being with us here this 

morning. Lehman Brothers, Financial Products Division, AIG, 

among others, I guess, you have heard Secretary Geithner and Fed 

Chairman Bernanke propose the creation of a resolution mecha-
9 

nism for nonbank entities as a way to move things forward. Obviously, you are talking about an area in which the SEC plays a very 

critical role. So, one, I would be interested to know whether or not 

you were consulted on this at all. We have talked about the Treasury Secretary and the Chairman of the Federal Reserve, but given 

the fact we are talking about entities that would normally fall 

under the jurisdiction of the SEC or the State regulators, were you 

at all consulted by the Treasury and the Fed? What role do you 

think the SEC should play in this resolution mechanism given the 

oversight and regulator responsibilities? And let me take advantage of the moment as well to ask you, if you would, to comment 

on the reports of the regulatory changes that Secretary Geithner 

has mentioned this morning. In fact, I will ask both of you to do 

that, but let me begin with Chairman Schapiro. 

Ms. SCHAPIRO. Thank you, Mr. Chairman. I would say broadly 

and quite generally there was consultation with respect to the concept of filling the gaps in the existing resolution regime, but really 

very little conversation about what that would look like and what 

the legislative proposal ultimately would propose. 

We clearly have gaps in our resolution regime for large financial 

institutions. SIPC obviously handles the unwinding and the liquidation of a broker-dealer. FDIC is empowered to handle the 

unwinding or the resolution of a bank, but we have bank holding 

companies and other large financial institutions for which there 

really is no organized resolution regime. And I do think that that 

was an issue, clearly an issue with AIG, but also an issue with 

Lehman Brothers and other institutions. 

So I fully support the concept of closing the gap in resolution regimes so that we have a more coherent approach. Whether that ultimately rolls SIPC, over which the SEC has authority, into it or 

it works to be highly coordinated and cooperative with an entity 

like SIPC I think is something we should probably discuss as this 

legislation moves forward. 

Chairman DODD. Let me just say on that point, before we move 

to the second question, whether they have consulted with you or 

not, I would hope that you would demand to be consulted on this. 

This is something where clearly this is—you are going to have a 

resolution of these entities here, given the role of the SEC in the 

regulation of them and the oversight of them. And I am very much 

supportive of the idea of having a resolution mechanism. I do not 

want to suggest I am not. But it seems to me you have got to be 

involved in this. 

Ms. SCHAPIRO. There is actually no question but that we have to 

be involved in this. The SEC has an enormously important role to 

play here as the expert. But, again, as I said in my opening statement, as the advocate for the investor whose funds are in potentially multiple components of a large financial firm, and most particularly, of course, the broker-dealer, and our concern will always 

be the protection of investors’ assets in the broker-dealers. 

So I am not known for being shy. I have no intention of being 

shy. 

Chairman DODD. Kick down the door, if you have to. 

Ms. SCHAPIRO. I will kick down the door. 
10 

Chairman DODD. Mr. Joseph—let me have you respond to this 

quickly, and then I want to get back to this—and do not take a 

long time on the second part of that question, but I would be interested in your general reaction to what you have heard this morning 

from Treasury and others on the modernization. 

Ms. SCHAPIRO. With respect to a systemic risk regulator? 

Chairman DODD. Yes. 

Ms. SCHAPIRO. Again, the devil is in the details on this one for 

sure, and my concern is that in the creation of a systemic risk regulator we do not create a monolithic entity that supplants the important functions that are served by multiple other agencies and 

most especially, in my view, the Securities and Exchange Commission and our role as a regulator of the capital markets with a focus, 

again, solely on investors and investor protection. 

So while I support the concept of either a systemic regulator or 

a college of regulators—which I think is a concept you have talked 

about; I know there is at least one bill proposed that would create 

that sort of a mechanism, and I think it is well worth exploring because I think multiple regulators bring a lot to the table and multiple perspectives. 

Nonetheless, whichever way we end up going, I think there is 

value to a view across the markets of large or rapidly increasing 

exposures that can threaten the health of the financial system. I 

think there is an important focus on evaluation of risk management procedures within large firms. I think there are certain prudential standards that ought to be established for very important 

systemic institutions. And I think a risk regulator can help the appropriate resolution authority in their functions. 

But I think what is really important is that while we try to create a mechanism like this, that we do not try to supplant the very 

important functions that are engaged in by agencies like the SEC 

in the regulation of markets, clearance and settlement systems, 

brokerage firms, mutual funds where Americans entrust their savings and so forth. 

Chairman DODD. Let me just say, my time is up here, and, 

again, I think Senator Shelby and I are both very determined to 

work very closely together on this, so I would not want any of my 

statements to be taken as a final conclusion on this. But as we talk 

about a systemic risk regulator and a prudential regulator, my own 

view is we put that together. I get somewhat uneasy about consolidation of a lot of this. It looks great on a sheet of paper in terms 

of doing the efficiencies of it. But I for one feel very strongly, at 

least at this point, that the SEC and the function of the SEC ought 

not to be so incorporated in something that it ends up diminishing 

the role of the Securities and Exchange Commission in investor 

confidence, investor confidence, investor confidence. 

Ms. SCHAPIRO. I completely agree with you. My fear is that a systemic risk regulator and systemic risk concerns will always trump 

investor protection. And given the structure of our markets and the 

broad participation of the public in our markets, that would be a 

terrible result. 

Chairman DODD. We are interested in your thoughts and views 

on this as well, but I would not want the moment to pass without 

expressing my reservations about moving a lot of boxes around and 
11 

consolidating things and assuming you are getting something better because you have got fewer boxes. 

Ms. SCHAPIRO. Thank you. 

Chairman DODD. In fact, the goal is that consumer, that investor, 

that shareholder, that user of the system, what is in their interest? 

You begin there. 

Senator Shelby. 

Senator SHELBY. Thank you, Mr. Chairman. 

Picking up on the area that Senator Dodd was in, Chairman 

Schapiro, the SEC’s Consolidated Supervised Entity Program, I believe was not a success. What role, if any, should the SEC—you are 

the Chairwoman of the SEC—play in prudential supervision? 

Ms. SCHAPIRO. I think it is—— 

Senator SHELBY. Can you bring the microphone up closer, please? 

Ms. SCHAPIRO. Sure. I am sorry. Is that better? 

Senator SHELBY. Yes. 

Ms. SCHAPIRO. I think the SEC’s Consolidated Supervised Entity 

Program was not a success. I think that is a fair evaluation. It has 

been replaced now because we obviously still have very important 

oversight of brokerage firms that have financial and operational 

issues that need the close supervision of the SEC, and it has been 

replaced by an Office of Broker-Dealer Risk Management. 

Nonetheless, our focus on the broker-dealer is very important 

and it is well ingrained in the SEC. But you can’t effectively oversee the broker-dealer and its operations if you don’t also have the 

ability to understand what is going on in a holding company or an 

affiliate, including overseas affiliates, whose activities can very, 

very directly impact the broker-dealer and the safekeeping of customer assets at that broker-dealer. 

So my view is that we have responsibility for brokerage firms, 

but we also have to have what we call a touch at the holding company level and at the affiliate level to understand risk management, exposures, leverage, and other issues that have implications 

for the broker-dealer’s health. 

Senator SHELBY. You have announced plans to consider reinstating the uptick rule, or a variation of the rule, at an open meeting next month. A lot of economic analysis was done before the rule 

was eliminated in 2007. How are you incorporating economic analysis into the decision about whether, and if so, how to reinstate an 

uptick rule? 

Ms. SCHAPIRO. Senator, you are absolutely right. We are going to 

consider at an April 8 Commission meeting proposing to reinstate 

the uptick rule, or a bid test, or a circuit breaker, or some combination of those as a mechanism for controlling short selling to some 

extent. We are obviously acutely aware of the tremendous interest 

in this issue on both sides. Economic analysis did play a very important role in the elimination of the uptick test and we would expect that our economists at the SEC are looking at data now in the 

context of the changes in the markets to understand what the impact of an uptick rule might be, and I would expect that we will 

make data available, to the extent we can, to independent economists to do some analysis, as well. 

We will also hold in conjunction with the open meeting where we 

will consider the uptick test a public roundtable where we will so-
12 

licit views more broadly about not just the uptick test, but other 

potential Governors on short selling. 

Senator SHELBY. The SEC’s examination function used to be integrated into each of the rulemaking divisions. Over 10 years ago, it 

was split off into a separate office. Some people have argued that 

this structure creates a dangerous wall between those who write 

the rules and those who monitor how firms are implementing 

them. Are you at the SEC reviewing this structure and how it continues to make sense, especially in light of the Madoff-Stanford financial and market timing scandals? 

Ms. SCHAPIRO. Yes, Senator, we are. I have only been on board 

about 2 months, not quite 2 months, and—— 

Senator SHELBY. I know that. 

Ms. SCHAPIRO. ——and reviewing the structure of the agency 

broadly is high on my list of things to get done. It is really critically important that we have an examination staff that has the 

tools and the skill sets to do a more effective job, the most effective 

job possible, but that is also linked back to the policymaking parts 

of the organization so that they can inform policymaking and they 

can also inform the Commission about areas where we may need 

to take further action. So I am looking very broadly at the structure of the entire agency and, of course, OC is a component of that. 

Senator SHELBY. You have also noted that the SEC may ask Congress for a statutory mandate that hedge fund advisors register. 

Would your request also extend to venture capital and private equity advisors, and how would the influx of new advisors affect the 

frequency with which advisors get inspected? 

Ms. SCHAPIRO. Well, it is a terrific question because right now, 

we have something on the nature of 400 examiners to cover 11,300 

advisors and more than 8,000 mutual funds. So without additional 

resources, we could not make, even given the authority to regulate 

hedge funds, we couldn’t make that a reality in a very effective 

way. 

Senator SHELBY. How much money are you going to need there? 

I know this is an Appropriations Committee question, but I am also 

on that committee. 

Ms. SCHAPIRO. We are working on that analysis right now and 

will be happy to provide it to the Committee as soon as possible. 

Senator SHELBY. OK. 

Ms. SCHAPIRO. Also, it is important, though, that in addition to 

resources, we need to have the skill sets that are appropriate in 

order to do an effective job with hedge fund regulation. 

Senator SHELBY. Thank you, Mr. Chairman. 

Chairman DODD. Senator Schumer. 

Senator SCHUMER. Thank you, Mr. Chairman. Thank you for 

holding the hearing, and thank you to the witnesses for being here 

today. 

My first question deals with executive compensation. It has become clear that something is out of whack with executive compensation. I think we all believe that people should be rewarded for 

good performance. That is not the problem. But what we have seen 

in many instances, that has enraged Americans, is a ‘‘heads, I win, 

tails, you lose’’ system, in which executives are rewarded for flashin-the-pan short-term gains, or even worse, rewarded richly when 
13 

the company does poorly and the shareholders have been hammered. I think that is what most confounds people—bad performance, higher salary. 

Corporate boards are supposed to keep an eye on compensation. 

They are supposed to keep it aligned with shareholder interests. 

Lately, they seem to have more interest in keeping the CEOs and 

top management happy than in carrying out their fiduciary responsibilities, so I think we have to address that. We have learned a 

lot about this in the last while. 

Last year, when he was a Senator, President Obama sponsored 

an advisory say on pay proposal. I think we have to look at this. 

I am for it. But for say on pay to have teeth, it seems pretty clear 

it requires shareholders to have a stronger voice in regard to corporate management. This obviously means shareholders need to 

have a real voice in the election of directors. Right now, given the 

fact it is so hard to get access to the proxy materials for nonmanagement shareholders, this isn’t true, so I was encouraged to 

hear in your testimony you don’t believe the SEC has gone far 

enough in this area. 

First, how are you proceeding to correct this, and do you agree 

with me that, in conjunction, real proxy access along with say on 

pay would have some real impact on compensation practices and on 

enhanced board responsibility more generally? 

Ms. SCHAPIRO. Senator, I agree with everything you have 

said—— 

Senator SCHUMER. Oh, well maybe we should stop right now. 

[Laughter.] 

Ms. SCHAPIRO. I could stop right there in the interest of time. 

Let me say quickly, I think there has been a lot of effort to link 

pay to performance, but there has been a nonsuccessful effort to 

link pay to risk taking and that is a responsibility for boards, to 

understand the appetite for risk within the organization and to 

control it, and one way to control it is through linkage to compensation practices for senior management. 

We will move ahead this spring to propose greater access to the 

proxy for shareholders as a mechanism both to empower shareholders, who are, in fact, the owners of the corporation, but also as 

a mechanism to help provide greater discipline with respect to compensation and risk taking. 

Senator SCHUMER. Thank you, and I look forward to working 

with you on this area. I think we need to move forward. 

Second is enforcement funds. We know—everyone knows about 

the Madoff case, but it is emblematic of a broader trend of fraud 

that I believe is going to be uncovered in the aftermath of this financial crisis. Back in the S&L crisis, I helped push a law that 

would get special prosecutors, FBI agents, and bank examiners to 

go after that fraud. Mr. Breeden is shaking his head because we 

worked together on that. And we need to do that again, particularly now. If you saw yesterday’s newspaper, the administration, 

correctly, doesn’t want to reduce antiterrorism efforts in the Justice 

Department, but that squeezes new needs, such as financial investigators. 

In conjunction with my colleagues on this Committee, we are trying to increase the SEC enforcement budget. I proposed legislation 
14 

to do that with Senator Shelby, which we are going to try to do in 

the Appropriations Committee. Can you give us a sense of what improvements you could make with a stronger enforcement budget? 

Ms. SCHAPIRO. I would be happy to, and we—— 

Senator SCHUMER. Or an increased budget in general, too. 

Ms. SCHAPIRO. We would be grateful recipients of an increased 

budget and particularly an increased enforcement budget. We have 

a new Enforcement Director beginning on Monday. He spent 11 

years as a prosecutor and head of the Securities and Commodities 

Fraud Task Force in the Southern District of New York. He is coming in with a renewed commitment to the SEC’s focus on bringing 

the most important cases, the most meaningful cases, in the 

quickest time possible in order to protect investors more effectively. 

We are also looking at technology improvements to support our 

enforcement and examination staff. The SEC’s technology is light 

years behind Wall Street, and frankly, light years behind everybody else. 

Senator SCHUMER. OK. 

Ms. SCHAPIRO. We have enhanced our training programs. We 

have a number of people who are now taking the Certified Fraud 

Examiner Program, as well as enhancing dramatically our internal 

training programs. And we are actively seeking new skill sets, including in financial analysis, forensic accounting, trading, and 

other areas, so that we are better able to keep up with what is 

going on and what the fraudsters are up to. 

Senator SCHUMER. Thank you. So I see you need the money. 

Could I ask one more, Mr. Chairman? Quickly, just on derivatives clearing. For a while, I have been advocating that derivatives 

ought to be traded whenever they can be—some are very complicated and there is no market—in either a clearinghouse, or for 

me, preferably, an exchange. I know that this morning, Secretary 

Geithner is going to mention that in his testimony, at least as I understand it, on the House side. 

What steps is the SEC encouraging to take to encourage the use 

of central counterparties? Do you have the authority to require 

clearing of certain types of derivatives now? If you don’t, is it the 

kind of authority that you want, and if not, what other kinds of authority do you need? 

Ms. SCHAPIRO. I believe that—— 

Senator SCHUMER. Do you agree with the general thrust? 

Ms. SCHAPIRO. Yes. CDS should be centrally cleared. We do not 

have the authority right now to require that. We have facilitated 

the approval of three central counterparties for CDS clearing that 

we have done jointly with the Fed and with the Commodities Futures Trading Commission and we would strongly recommend that 

Congress require central clearing of CDS. I am not a big believer 

in voluntary regulation and I think that this is an area where we 

need authority. 

Senator SCHUMER. Thank you, Mr. Chairman. 

Chairman DODD. Thank you very much. 

Did I hear you say in response to Senator Schumer on the way 

on pay that you are inclined to be supportive of that in terms of 

shareholder—— 
15 

Ms. SCHAPIRO. I do support say on pay, the advisory vote by 

shareholders of pay, yes. 

Chairman DODD. Good. Thank you for that. 

And let me just say, too, as I turn to Senator Corker, there are 

some wonderful people who work at your organization and I 

wouldn’t want our comments to talk about needs and resources and 

so forth to be reflective of how many of us feel about how hard 

working people are at the SEC. They need the tools, as Senator 

Schumer points out, the resources and so forth there, but it is not 

for lack of determination of good people who want to do a good job, 

and I think that needs to be said. It can’t be said often enough. 

Ms. SCHAPIRO. I appreciate that very much. 

Chairman DODD. Senator Corker. 

Senator CORKER. Thank you, Mr. Chairman, and thank you all 

for being here and for your testimony. 

I just, in looking at my BlackBerry a second, would recite a quote 

from Secretary Geithner this morning on the other side of the Capitol. We have a moment now where there is broad-based will to 

change things that people did not want to change in the past. 

I am getting a little feeling of nervousness just about the pace 

at which change is taking place. Typically, when you move in crisis, 

you end up with not having a cause-neutral solution, OK. I would 

just say to you, if you are going to be kicking the door down, the 

kicking is good right now. I mean, you are going to miss an opportunity if that doesn’t happen very quickly, and I would just ask 

your opinion of some of the resolution authority concepts that were 

laid out in the last 24 hours. 

It feels to me like a codification of TARP. The very powers that 

the Treasury has now under TARP, it seems to me they are codifying under this proposal they have put in place, which allows 

them to not only take companies down, but to decide to invest in 

companies. I just wonder if you have any thoughts there and does 

that concern you in any way. 

Ms. SCHAPIRO. It does concern me. I think any time we write 

blind check legislation, as I sometimes call it, we have to be very 

conscious of the fact that we could set in motion a complete rewrite 

of the regulatory regime without perhaps truly intending to do 

that. So I think it is really critically important the Congress stay 

deeply involved in this discussion and this debate and set the parameters. 

So, for example, the definition of a systemically important institution is absolutely essential, and if it is very, very broadly defined, 

that resolution regime or the systemic risk regulator could usurp 

the functions of multiple other regulators, and as you know, my 

concern is also usurp the importance of investor protection and capital markets regulation in doing so. 

So I think it is really an area where Congress needs to stay involved so that we don’t end up with such broad legislation that we 

define the regulatory regime without the input of the broadest 

number of perspectives and without really careful thought to what 

the implications are to the other functions that are important in financial regulation. 

Senator CORKER. Mr. Chairman, I think we have seen that TARP 

was set up for an intended purpose and we have moved into indus-
16 

trial policy. The last administration did that. This administration 

looks like it is going to move more deeply into industrial policy. 

And it seems to me that what the Secretary has outlined this 

morning truly gives them the ability to move into any sector of our 

economy that they choose that they decide might be systemically 

putting our economy at risk, and I think we should heed Ms. 

Schapiro’s comments here. This is a fearful time. The public is concerned, and lots of time bad things happen legislatively as a result 

of people being concerned. 

Let me ask you this. Do you agree or disagree that hedge funds, 

derivatives, private equity ought to be regulated? 

Ms. SCHAPIRO. I do not disagree. I believe they should be regulated. 

Senator CORKER. And to follow up on Mr. Schumer’s comment— 

and obviously, how they are regulated makes a huge difference, 

would you not agree? 

Ms. SCHAPIRO. Absolutely. 

Senator CORKER. I mean, we could, in fact, I guess, run all three 

of those enterprises to other places if we regulate them inappropriately, is that correct? 

Ms. SCHAPIRO. That is right, so we need to be sensitive to the 

fact that a hedge fund is not a mutual fund, and we need to understand the differences in how those investment vehicles work and 

tailor the regulation appropriately. 

Senator CORKER. And we still want private equity to take risk, 

right? 

Ms. SCHAPIRO. Absolutely. 

Senator CORKER. I know there is not time right now. I would love 

to hear your thoughts on how you regulate private equity in such 

a way as to allow them to continue to take risks, which is what 

we want them to do, and yet be somewhat under their hood. So 

maybe you will answer that a little bit later. 

I want to ask you one last thing, because time is so short. We 

have so many panel members. Credit default swaps, I think we all 

understand some of the problems that have occurred. There have 

been people that have advocated that credit default swaps are like 

off-track betting if you don’t have any skin in the game. And so I 

would love to hear your thoughts as to whether credit default 

swaps should only be used when you have some collateral that you 

are actually insuring against, or whether you ought to be able just 

to make bets with no collateral. 

Ms. SCHAPIRO. It is a terrific question and it is one where there 

are very strongly held views on both sides, whether there should 

be skin in the game in the sense that you have an insurable interest before you engage in a credit default swap. We don’t have an 

agency perspective on that. I think it is actually an issue very 

much worth exploring as a mechanism to control some of the risk 

in the system. 

I can’t tell you I am sophisticated enough to know all of the implications of requiring an insurable interest before engaging in a 

credit default swap and exactly how you would define that. But I 

think it is an issue that is worthy of consideration. 
17 

Senator CORKER. Well, my time is up, but my sense is that you 

feel like the Treasury’s proposal, as outlined in the last 24 hours, 

could be very much a power grab, is that correct? 

Ms. SCHAPIRO. I certainly wouldn’t use those words—— 

Senator CORKER. But I am using them, and I would love to have 

a yes or no on that. 

Chairman DODD. Nice try, Senator. 

[Laughter.] 

Ms. SCHAPIRO. I think the devil—I believe the devil is in the details. I believe it is really important we understand what it is exactly that we are proposing to do and what the implications are for 

the regulatory regime and for investors broadly. 

Chairman DODD. Thank you, Senator. 

Let me just say, too, to my colleague from Tennessee, whose 

judgment and counsel I take very seriously, as well, this Committee will be very involved as we listen to the proposal on the resolution mechanism. I said I am generally supportive of the idea of 

having some sort of a resolution mechanism. What shape that 

takes and how it is organized and structured is something this 

Committee will be deeply involved in, and so—— 

Senator CORKER. I sure hope so. The way things have laid out, 

Mr. Chairman, I would rather be Treasury Secretary than chairman of the universe, so I hope we will be involved. 

Chairman DODD. Well, be careful what you wish for. 

Senator Warner. 

Senator WARNER. Better than chairman of the universe? That is 

a high standard. 

Well, thank you, Mr. Chairman. I know my time is short, but I 

would like to echo what my colleague said. In the Chairman’s response to the skin in the game question about credit default swaps, 

I know there are a number of other arguments on the other side. 

I would like to hear out those arguments because it does seem to 

me that from at least a broader-based societal standpoint, the outside risk and the downside risk that we as a society, in effect, have 

taken on by these nonskin in the game offside bets, we are sure 

seeing the downside of that. 

I would like to come at this, maybe look at it from the top and 

maybe from the bottom in one of the questions, bottom up, and you 

having served in the role of FINRA. I understand the need for selfregulatory organizations in light of the limited resources you have 

at the SEC to have the oversight on the number of institutions you 

have to cover, but we had a previous hearing here a month or so 

back on the Madoff schedule and it seemed where they were passing responsibility representatives from the SEC and FINRA about 

where boundaries ended and how far you could go and at what 

points the operator of an institution could, by simply defining that 

this was off-limits, could stop investigations. 

Have you looked through your overview, Chairman Schapiro? 

Have you looked at, kind of a fresh eye look at all of the SROs and 

what their role and function should be going forward? 

Ms. SCHAPIRO. We have not yet. That is something we will do, 

because I think it is very important. The SEC is responsible for 

about 30,000 regulated entities, including about 12,000 public companies. We have a staff of 3,600 people. We have got to have the 
18 

ability to leverage third parties in order to do our job, which is not 

to say in any way that we would ever abdicate our responsibility 

or delegate our responsibility away. But whether it is accounting 

firms or SROs, the PCAOB or other entities, we need the ability 

to utilize them to help us get our jobs done. 

I think what the Madoff matter points out to me that I think is 

something we need to focus on, and I alluded to in my oral testimony and in more detail in the written, is that we do have doubts 

in the regulatory regime and a particular area of concern, and Fred 

Joseph raised this, as well, is the different standards of care and 

the different regulatory regimes that govern investment advisors 

and broker-dealers when they are providing largely the same service, and investors clearly don’t understand that there is either a 

different standard of care or a different regulatory regime in place. 

Those are the kind of gaps that we absolutely need to fill and we 

need to do so from the perspective of the investor so that they are 

getting uniform protections and standard of care and regulatory 

oversight regardless of what the title is of the person who is offering them financial services, and that is an area where I think we 

need to be very focused. 

Senator WARNER. I would love to come back and pursue that 

later, but I have got two other areas and my time is short. 

One is, following up on Senator Schumer’s comments, and I was 

appreciative of your comments that the Chairman brought out, as 

well, on say on pay. But I do think that at some point, this Committee also needs to take a look at corporate governance. I believe 

a lot of good things may have come out of Sarbanes-Oxley. One of 

the challenging things that came out of Sarbanes-Oxley is I think 

it is even tougher to get good quality board members to serve on 

public companies. I would actually believe that one of the unintended consequences of Sarbanes-Oxley may be that chairmen of 

companies end up getting even more captured board members because so few folks, other than maybe their friends, would want to 

serve on a public board at this point. 

I have explored the option of looking at institutional investors, 

could we create an effective cadre of qualified potential board members so that we really could look at the issue of how we bring some 

real independence and broader-based oversight on corporate governance, and I just wonder if you had any kind of initial 

thoughts—— 

Ms. SCHAPIRO. We would love to work with you on that. We are 

engaged right now in a pretty complete review of corporate governance issues at the SEC, everything from linking—disclosure concerning pay and its linkage to risk taking, risk disclosure more 

generally, qualifications of board members, and access to the proxy 

as a way to try to facilitate more independent boards that are more 

responsive to shareholders, and my view is we will take all good 

ideas and put them into the mix and see if we can come up with 

a system that works better for U.S. shareholders than the one we 

have—— 

Senator WARNER. I do think we need something to make sure the 

board members don’t get captured as quickly and often as they do. 

One last question. I know my time is up, but this could be perhaps an easier one. I know you are going to deal with the uptick 
19 

rule, but I wonder, as well, if you are looking in terms of short selling at some type of real-time disclosure component for short sales 

so that the market could know on a real-time basis the position of 

the number of shorts. 

Ms. SCHAPIRO. We are, as you point out correctly, talking about 

the uptick rule at an April 8 Commission meeting. We are looking 

at a wide range of possibilities and disclosure is certainly one of 

them with respect to short selling, hard borrow, just the broad panoply of possibilities in this area. The one that is most advanced is 

the possibility of reinstating the uptick rule at this point. 

Senator WARNER. Thank you. Thank you, Mr. Chairman. 

Chairman DODD. Thank you very much. 

Just on that last point Senator Warner has raised, as well, I 

wonder if you will also look at margin requirements. The difference 

between exposing weakness, which short selling does and has very 

great value, versus speculation, which has been, I think—you 

know, people have talked about mark-to-market. The quickest 

thing you might do about mark-to-market is get this uptick rule in 

place, in my view, and then look at the margin requirements as 

Richard Breeden talked about. 

Ms. SCHAPIRO. Yes, it is in former Chairman Breeden’s testimony. 

Chairman DODD. Yes. Senator Johanns. 

Senator JOHANNS. Thank you, Mr. Chairman, and let me just say 

to the Chairman and Ranking Member, this is another excellent 

hearing. 

If I could, I would like to focus our attention in my limited time 

on Mr. Madoff and his Ponzi scheme, and I will offer an observation to start out with, and I don’t suggest this in a necessarily critical way, but I am very skeptical, and I think there is reason for 

that skepticism. I hear your need for more people, more money, 

more staff, the vast regulatory responsibility you have. But I look 

back on the Madoff case and there is, I think, a fair amount we 

know today. There is a fair amount we probably don’t know because of the ongoing investigation that we will learn as time goes 

on. 

But you have a gentleman out there, for lack of better terminology, I will call him a whistleblower, who I think pretty effectively blew the whistle, and having been in your position as a cabinet member and having regulatory responsibilities also, I read 

through that information that he provided to you folks and, boy, I 

would liken it to dropping a grenade in the Secretary’s office. I 

mean, it is explosive. It sets up the possibility that everybody’s investment is at risk, if not literally disappearing. 

And I put myself in that position and I think about, boy, I would 

have had the Inspector General, the Department of Justice, I 

mean, anybody I could have reached out to and grabbed onto to 

help me deal with that issue, and yet we went along here and now 

today we learn that maybe a billion dollars will be recovered out 

of some $65 billion. 

Now, I am very mindful of the ongoing investigation. I don’t want 

to interfere with that. I certainly understand that. But what I want 

to start to understand is what went wrong, because if we don’t understand what went wrong, then we can’t be very effective in de-
20 

signing a regulatory framework that protects the consumer. What 

assurance can we have as the Committee that when the next whistleblower shows up, it will be different because of some action we 

have taken as the U.S. Senate or as the Congress to try to deal 

with these issues? So help me start to understand that. 

Ms. SCHAPIRO. I would be happy to, and let me say very clearly 

that I don’t lay the blame for the SEC’s failure to respond appropriately to the Madoff to the whistleblower’s information provided 

to the agency at the feet of a lack of resources. As you rightly point 

out, a fairly complete set of information was provided over a period 

of years to the agency and wasn’t follows up on appropriately. So 

in this instance—we do have resource issues. In this instance, I am 

not sure we can blame resource issues. 

The Inspector General, as you correctly point out, is investigating, and that is going to take a number of additional months. 

My view is I need to run this agency in the meantime and I am 

not really anxious to wait four or five additional months to find out 

what went wrong and then start to fix our problems, because as 

you also point out correctly, we can’t fix it if we don’t understand 

how we failed. 

My belief is that there are multiple things that contributed to the 

agency’s failure to act and there are a number of things that we 

can do and have started to do in response. One is that we have a 

stovepiped approach within the Securities and Exchange Commission, where information is not freely shared across offices and 

among departments and divisions the way it ought to be and the 

way that you would hope for in an agency that was really operating 

efficiently. 

We have very disparate processes for handling the between 

700,000 and a million-and-a-half tips and whistleblower complaints 

that come into the agency on an annual basis and we don’t have 

all the right skill sets. So that information may well have landed 

with somebody who didn’t understand at all what they were looking at, and because the culture isn’t normally one of sharing information easily, it didn’t get sent necessarily to the right place. 

Those are all things that we can do something about. We have 

engaged the Center for Enterprise Modernization to come in and 

review all of our processes for handling those 700,000 tips and complaints and helping us build the technology that will allow us to 

mine those that are most productive. We will come back to this 

Committee and ask for whistleblower legislation that will allow us 

to compensate people who bring us fully formed, well documented 

instances of abuse or fraud that we can then pursue from a law enforcement perspective. We are bringing in new skill sets and people 

with the ability to look and understand the data that they are looking at. 

And finally, it is the job of the leaders of the agency, myself, 

most especially, to try to break down the walls that exist between 

departments and divisions so that sharing information and viewing 

ourselves as engaged in a common enterprise is the way we approach our work, not as divisions competing sometimes with each 

other. 

So we have a lot to do in this area. I am fully committed to fixing 

every problem that we have as best as I possibly can. I have only 
21 

been there 2 months. I think we have gotten a lot of things started, 

but it is going to take time and effort to refocus the efforts and the 

energies of the agency on protecting investors from exactly this 

kind of conduct. 

I will say that in the last couple of months, the Ponzi scheme 

TRO machine has been fired up and you will not see a week go by 

where we are not bringing Federal court cases against Ponzi 

scheme operators and trying to stop them at a much, much earlier 

point in time. 

Senator JOHANNS. I appreciate the candor of the answer. I think 

you acknowledge there were some things here that just simply 

were missed. 

My time is up. Here is what I would ask for—because this is 

going to unravel over time. The investigation will continue, but at 

some point it will conclude. My hope is that when there is a full 

and complete picture and we can have an open and candid discussion about what the investigation showed, et cetera, that we do 

that. We owe that to the people who have lost so much. And so I 

hope you will work with the Chairman and the Ranking Member 

and the Committee Members to help us just nail this thing down 

in terms of what happened and why it is not going to happen in 

the future. 

Ms. SCHAPIRO. I completely agree that the Congress, as our oversight body, is entitled to understand that, and the American public 

is entitled as well. 

Senator JOHANNS. Great. Thank you. 

Chairman DODD. Let me just say in that regard, too, Jack Reed 

and Senator Bunning are the Chair and Ranking Member of the 

subcommittee dealing with securities. And today is an abbreviated 

session with the Chairperson of the SEC, but I commit to my colleagues this will be an ongoing conversation both formally and informally. We will find means by which we can pursue these matters, and certainly as Chairman Schapiro knows, we have made 

some requests which the SEC—in fact, the Chairwoman indicated 

to me this morning—will be getting back to us immediately on 

some requests the Committee has made regarding this matter, and 

we welcome that very much. It is very much in line with what the 

Senator has requested this morning. 

With that, Senator Tester. 

Senator TESTER. Thank you, Mr. Chairman, Ranking Member 

Shelby. I appreciate the hearing. Thank you both for being here. 

This is a question for both Chairwoman Schapiro and Mr. Joseph. I had conversations around the State, as I am sure we all 

have, with constituents, regulators, and finance professionals in 

Montana, and there is pretty much unanimous consent that one of 

the biggest, if not the biggest, threat to our economy right now is 

a lack of confidence in the marketplace. Families fear their retirement accounts and all their investments are not as safe as they 

once were. What do you feel in your individual capacities is the 

most critical step that we can take to restore consumer/customer 

confidence? You will both get a chance, so go ahead. 

Ms. SCHAPIRO. You know, there are so many pieces to restoring 

investor confidence. From the perspective of the SEC, we really 

have to show a single-minded commitment to putting investors first 
22 

in every single thing we do. That means aggressive enforcement so 

that investors understand that there is a penalty and a price to pay 

for abusing investor trust. It means ensuring that the corporate 

disclosure that investors get so they can make rational decisions 

about how to allocate their capital, whether to buy a stock or to 

buy a mutual fund, is absolutely honest and transparent and readily available to them. 

It is ensuring that post the reserve fund ‘‘breaking the buck’’ and 

scaring everybody about the resilience of money market funds, that 

we understand those issues and that we move quickly to enhance 

the liquidity and quality of paper that is held in money market 

funds. 

For us, it is really doing what we do every single day, but with 

the single-minded focus on investors and ensuring that our efforts 

are urgent and aggressive. And beyond that, I think obviously the 

economic stabilization programs need to play out. People need to 

see credit flowing again. They need to have faith that the people 

that they are dealing with are going to be honest, and enforcement 

is obviously a huge component of ensuring that. 

Senator TESTER. Thank you. 

Mr. Joseph. 

Mr. JOSEPH. Thank you, Senator. I agree with the Chairman. 

Her comments are right on. And you are correct, the whole system—the entire financial system—is built on trust and confidence. 

And at the moment I think that is a little bit shaky. If people do 

not believe they are on a level playing field, and if that does not 

happen, obviously they are not going to invest. 

I agree that we need to focus on investor protection. I believe we 

need to be certain that the people who are licensed to sell securities 

are adequately prepared and qualified to do so. The securities that 

they are selling, for example, the Reg. D Rule 506 offerings, need 

more regulatory scrutiny; otherwise, in some cases it is just pure 

gambling. 

Senator Dodd also pointed out that in some cases it is speculation. Senator Dodd, I would say it is speculation at best and gambling at worst in some cases. 

Last, we need to enforce, and enforce strongly. And I believe the 

SEC and the States must continue on in that role, and we take our 

roles very seriously. 

Senator TESTER. Thank you. One quick comment before I get to 

my next question. Chairwoman Schapiro, I appreciate your consideration of the uptick rule. There is a bill that Senator Isakson, Senator Kaufman, and myself are on to reintroduce it, and I think it 

could help, reinstituting that rule that was taken away after 8 

years. I appreciate you taking that up. 

I want to talk just very briefly, because I have only got a minute 

left, about the power of a monolithic regulatory scheme versus a 

patchwork scheme that we have now of regulation that, quite 

frankly—and I think it was your predecessor who said that there 

was no regulation in some of these financial instruments, and it is 

one of the reasons we are at this point, at least from my perspective. 

There seemed to be a lack of consistency with the patchwork 

scheme because of gaps that inherently open up. Then on the other 
23 

side of the coin—and I do not want to put words in your mouth— 

you talked about one agency could get too powerful, and I agree 

with that, too. 

So how do we solve the problem? How do we solve the problem 

of gaps and people saying, well, I really do not have authority to 

regulate this, it is somebody else’s authority, and they are saying 

the same thing and things fall through the cracks? 

Ms. SCHAPIRO. I think it is critically important that we fill the 

gaps, first and foremost. We will have overlap, and I think that 

does create some tension among regulators. But as compared to 

gaps, that is a pretty manageable process, and sometimes the creative tension that evolves between banking and securities regulators actually results in a positive. 

But as we identify those areas of the financial system that have 

not been subject to regulation—hedge funds, credit default swaps, 

other kinds of pooled investment vehicles—it is important that we 

decide that if they are important to investor protection, if they are 

important to the financial system, that they be brought under the 

Federal regulatory umbrella with the support, obviously, in multiple areas of State regulators as well, and that those gaps basically be filled by a functional regulator. 

I think there is also a role for a systemic risk regulator, again, 

whether it is done by an individual institution that has responsibility for monitoring exposures and working on prudential regulatory standards and working with a resolution regime or with a 

college of regulators, there has to be heightened sensitivity to these 

components of the financial system that have not been regulated. 

Senator TESTER. In an ideal system, you are right. But what happens when you have a lack of resources? How anxious are you to 

jump on some other regulatory financial mechanism out there if 

you can say, well, gosh, this really is not my job anyway, and I am 

limited in financial resources, we will let somebody else take care 

of it? 

Ms. SCHAPIRO. It is really our responsibility, and we should not 

be in these roles if we are not willing to come to Congress and say 

this is a problem, we need your help, we need legislation, we need 

resources. 

Senator TESTER. Thank you. 

Thank you, Mr. Chairman. 

Chairman DODD. Thank you very much, Senator. 

Senator Martinez. 

Senator MARTINEZ. Thank you, Mr. Chairman. 

Madam Chairwoman, I wanted to follow up on a question that 

Senator Johanns had asked regarding the Madoff situation, and 

that is not really where I was going, but I heard your response, and 

it sparked the old lawyer in me. I just wanted to ask, when you 

said that if not resources, it was not resources that prevented the 

SEC from more aggressively pursuing the Madoff matter, then you 

went into a series of more technical issues involved in that. But if 

it was not resources, that goes to some other motivation. What do 

you attribute that to? 

Ms. SCHAPIRO. What I intended to say is that I do not lay the 

problems with Madoff solely at the foot of a lack of resources. The 

information came into the agency over a period of years. It is not 
24 

clear to me yet—and we have, obviously, an Inspector General review ongoing right now—whether it was people who received the 

information did not understand the import of it and, therefore, did 

not pursue it, or they did not send it to the right people who could 

understand it and analyze the data that was contained therein. 

We have very disparate processes throughout the agency around 

the country in all of our offices for how we handle the massive 

amounts of data that come into the agency. Whether it fell through 

the cracks or somebody just did not understand what they were 

doing, I cannot—I do not know. I would tell—— 

Senator MARTINEZ. So you do not know at this point. You are 

still undergoing an investigation. You have not reached a conclusion. 

Ms. SCHAPIRO. No. 

Senator MARTINEZ. You just do not think it was a lack of resources as such. It was more about either an understanding of it 

or an unwillingness to understand it or it just did not get to the 

right person. 

Ms. SCHAPIRO. It is one of those things, and my view is that we 

will fix all of those things, on the assumption that it is one of those 

things that has caused the agency not to pursue that information 

when it came in the door. 

Senator MARTINEZ. The issue I really wanted to get to is the 

issue of systemic risk. I know there has been some commentary 

from the Secretary of the Treasury about this as part of this new 

regulatory situation, and I wondered if you could define for us how 

you view systemic risk. 

In the old days of, you know, Fannie and Freddie concerns, obviously their size was a concern, and view them by size alone as perhaps posing a systemic risk. I think that has been proven all too 

much to be true. And also their capital requirements were fairly 

thin, which I think also made them, again, a systemic risk. 

How do you define what is the systemic risk that we need to be 

looking for? 

Ms. SCHAPIRO. That is probably the $64,000 question, because I 

think how you define it matters very much in how we ultimately 

structure any kind of a systemic risk regulator. Certainly, size 

would be a component. Relationship to other important financial 

institutions within our economy or—— 

Senator MARTINEZ. Interlink between those? 

Ms. SCHAPIRO. Interdependency or interlinkage; the amount of 

leverage. I think it matters very much how we define it, because 

there are a lot of criteria that can go to this issue, and how we define it will define how we regulate it. And whether we have a monolithic approach, a college of regulators approach, or a functional 

approach with some kind of overlay of systemic risk oversight that 

monitors exposures, perhaps requires the reduction of leverage, requires other prudential capital or other standards to be put in 

place, those definitions matter greatly. 

Senator MARTINEZ. How do you think we will come to a definition? Is this something that the Secretary of the Treasury is going 

to define for us? Or is that part of what we—— 

Ms. SCHAPIRO. Well, I hope the Congress will be very much engaged in coming to that definition and that the other regulatory 
25 

agencies that have profound responsibilities for components of the 

financial regulatory system will be engaged in that process as well. 

Chairman DODD. Let me say something. We had a witness the 

other day that said something that I think was very important. I 

think we talk about this in the singular, and I think that is sometimes where we are narrowing ourselves. He called it ‘‘systemic 

risks.’’ And I think that is a more appropriate wording, because 

there are—there are numerous risks. It could be the size of the operation, the practices and products of the—there are a lot of systemic risks that we ought to be looking at. Hence, one of the reasons why I am gravitating toward this college idea or commission 

idea rather than a single regulator idea, so that we have the ability 

to understand the risks that are posed to our system in a sense. 

I do not know if you agree with that. 

Ms. SCHAPIRO. I do agree with that. I think there are many, 

many small risks that, accumulated, become systemically threatening, and so I think—— 

Chairman DODD. I did not mean to interrupt. I apologize. 

Senator MARTINEZ. No, that is fine. I appreciate it. 

Ms. SCHAPIRO. ——the definition process is very, very difficult 

here. 

Senator MARTINEZ. But as a result of having a regulator in place 

that would be strong enough to then monitor these entities that we 

will have defined, we will then be able, going forward, to probably 

have a better handle on this. How do we at this point regulate 

those entities that appear to be systemically risky or provide systemic risks? Is there anything we can do at the moment going forward prior to a regulatory system being redeveloped? 

Ms. SCHAPIRO. Well, what I think we have seen develop over the 

last year is a bit of a patchwork and an ad hoc approach to dealing 

with institutions like Lehman Brothers and Bear Stearns and obviously, as is playing out very much right, AIG where it is an effort 

on the part of multiple regulators to use whatever tools they have 

available to them to try to reduce the risk or resolve the issues 

with respect to particular institutions. 

Senator MARTINEZ. But is there a coordinating—I know my time 

is up. But is there a coordinating point, is there someone—I mean, 

in other words, it seems to me that with AIG, you know—is it 

Treasury? 

Ms. SCHAPIRO. It has largely evolved to be the Treasury working 

most closely with the Federal Reserve, in some instances with the 

FDIC, in some instances with the SEC. 

Senator MARTINEZ. But that is my concern, that it is not clear 

to me when something like bonuses go out the door—which may, 

by the way, be perfectly a legal obligation that the company had. 

But there does not seem to be a clear understanding of who was 

at the end of the day providing the oversight that would have 

known precisely what was happening. And we are talking so many 

billions of dollars that it seems to me that needs to be defined before we get to a more permanent regulator. 

Ms. SCHAPIRO. I agree. 

Chairman DODD. Thank you very much. 

Senator Menendez. 

Senator MENENDEZ. Thank you, Mr. Chairman. 
26 

Madam Chairlady, I appreciate your statement, particularly 

where you said if there ever was a time when investors needed and 

deserved a strong voice and a forceful advocate in the Federal Government, that time is now. And you went on to make a series of 

positive statements that I think are very powerful, and I appreciate 

that. 

In pursuit of those statements and in pursuit of what I asked 

you during your confirmation process, could you tell me what since 

your confirmation—and I understand it has been about 2 months 

or so—what steps you have taken within the Securities and Exchange Commission to increase enforcement and investor protections? 

Ms. SCHAPIRO. I am happy to do that. We have announced the 

appointment of a new enforcement Director who begins on Monday, 

a long-time Federal prosecutor who also ran the Commodities and 

Securities Task Force in the Southern District of New York. We 

have retained the Center for Enterprise Modernization to help us 

overhaul tips and complaints as they come into the agency so that 

we can have a better handle on and pursue those tips and complaints that are most likely to produce important investor protection enforcement cases for the agency. 

I ended the penalty pilot program which required that the Commission’s enforcement staff pre-negotiate with the Commission before they could suggest a fine against a public company. We have 

speeded up dramatically the process which authorizes the staff to 

issue subpoenas in enforcement investigations. 

We have instituted new training programs. Our hiring now is focused on bringing in people with new skill sets that are in forensic 

accounting, financial analysis, and trading and operations. We are 

working on our technology. We have a long way to go there. And 

we have been very fortunate to have sufficient resources this year 

to actually do some hiring in the enforcement program, which had 

declined, as you may know, by about 5 or 6 percent over the last 

couple of years. 

So we have a new sense of urgency, and we have started to put 

into place tools that I think will really result in much more aggressive, much faster enforcement. 

Senator MENENDEZ. Well, I appreciate that you were ready for 

my question. 

Ms. SCHAPIRO. I remember the confirmation hearing. 

Senator MENENDEZ. And I am happy to hear your answer, to be 

very honest with you, so I appreciate your progress there. 

You know, I have told some of those in the investor community 

that you have only been there 2 months and give it time. Some of 

them are worried that you will not take the tougher steps that are 

necessary, and particularly on proxy access. I saw that you mentioned that in your statement. I think Senator Schumer asked you 

a question on this, and I appreciate what you said. 

I just want to visit with you on that issue. Is this something that 

you still remain committed to offering investors, a path to nominate their own candidates for board seats on company proxy ballots? And if so, give us a sense of your timeline for addressing what 

is a very important investor issue. 
27 

Ms. SCHAPIRO. I remain very much committed to that, and it is 

my expectation that—I believe we are tentatively scheduled, the 

Commission, to consider this issue in May—if not May, June, but 

certainly in the first half of this year. 

Senator MENENDEZ. Let me ask you one other question. Have 

you had the chance to look at the question that many in the Enforcement Division of the SEC move on to be employed by Wall 

Street firms? And there is some concern that there may be a conflict of interest there. Is that a revolving door, or is that something 

that you feel is OK? 

Ms. SCHAPIRO. It is a revolving door. We talked about this at my 

confirmation hearing, and I made a commitment to talk with the 

bank regulators who actually have in place some limitations on 

their examination staff’s ability to move freely from the agency to 

an entity that was otherwise examined by the agency. 

My counterbalancing concern is that I want to attract the best 

and the brightest people to the SEC, and if I make it too hard for 

them to leave, I may not get them in the first place. So from my 

perspective, it is a balancing act, but it is something that I continue to be committed to looking at and hopefully will get to before 

terribly long. 

Senator MENENDEZ. Finally, let me ask you, in light of the recent 

intense pressure from financial services lobbyists on accounting 

standard setters over fair value accounting, what will you and the 

Commission do to ensure that accounting standard setters remain 

independent so that they can fulfill their mission of serving the 

needs of investors rather than the short-term interests of some of 

the industry? 

Ms. SCHAPIRO. Well, I completely agree that that is a critical 

function for the SEC to help protect the independence of FASB and 

the accounting standard setters. And I understand there is tremendous emotion and concern about fair value accounting right now 

and any impact that it may be having. But our guiding light on 

this is that investors have told us that fair value accounting is important to them. It is important to their understanding of financial 

statements and their confidence in the honesty of those statements, 

and that is critical for them to make decisions about the allocation 

of capital. 

So we will continue to be vocal proponents of the independence 

of FASB. I think it is one of the tremendous strengths of our corporate disclosure system, which is unsurpassed in the world, and 

largely as a result of having an independent, highly expert body 

that sets accounting standards. 

Senator MENENDEZ. All right. Well, so far so good. Thank you, 

Madam Chairlady. 

Thank you, Mr. Chairman. 

Chairman DODD. Thank you very much. 

Senator Bennett. 

Senator BENNETT. Thank you very much, Mr. Chairman, and, 

Madam Chairman, Mr. Joseph, we welcome you here and appreciate your public service and the efforts that you are doing, and 

yours, Mr. Joseph, is public service too, even though you are not 

on the Federal payroll. 

Mr. JOSEPH. Senator, I am here for you. 
28 

Senator BENNETT. We are grateful for people who serve who are 

not on the Federal payroll. 

Madam Chairman, you talked about balance, and as I listened to 

all of this, I think balance is a word we need to keep very much 

in front of us—the balance to get the good people and at the same 

time try to keep our eye on potential conflict of interest. 

In times of crisis, the impulse is always to go absolutely in the 

direction of protection against everything else, and the ultimate 

protection of investors to make sure that they do not lose any 

money would be to shut down the market, because as long as there 

is no market, nobody is going to lose anything. And, obviously, we 

do not want to do that because it is the power of the American 

market that has allowed entrepreneurs to make America not only 

very profitable but truly unique. 

I have done business around the world. I have owned businesses 

in other countries and done business with companies from other 

countries. And the American entrepreneurial spirit is indeed 

unique and the driving force, I think, behind our long-term prosperity. 

So striking the balance between regulation that will find the Bernie Madoffs and get rid of them, which the public clearly needs to 

do, and allowing the markets to work is, I think, philosophically 

your biggest challenge. 

Ms. SCHAPIRO. I could not agree more. 

Senator BENNETT. Do you want to respond to that? Have you had 

any late-night thoughts in a quiet room about that? Or have you 

been so overwhelmed with the details you have not gotten around 

to thinking about it? 

Ms. SCHAPIRO. It is a question we confront really every single 

day, in small issues and large. How do we keep the balance right? 

How do we do exactly as you say, assure the protection of investors, the integrity of the marketplace, but not regulate everything 

within an inch of its life so that we do not have any more innovation and we do not have any more opportunity for people with 

great ideas to bring them to the marketplace? 

I do not have any wisdom, certainly no more wisdom than you 

have on this. I just think it is something we have to think about 

as we approach every single issue. And it is one reason I like very 

much to have a broad and diverse group of people within the agency and on my personal staff to consult with me on issues, because 

they bring those different perspectives and they will tell me to slow 

down, not to get caught up in the moment, and think about the implications of each and every thing we are doing. And I hope we will 

bring that very deliberative process to all of the issues—which is 

not to say we will not have lots of disagreements with different 

constituencies, but we will always try to get the balance right. 

Senator BENNETT. That is my concern, one of my concerns with 

respect to the proposals that we have before us to restructure our 

whole regulatory system. Systemic risk, let us give that to the Fed; 

safety and soundness, let us give that to FDIC; and then transparency and business practices, let us give that to the SEC, and 

you will all see to it that there is no problem of any kind anywhere 

else. 
29 

I was a new Member of this Committee right after the RTC circumstance, and there was an overreaction to the question of making sure every institution is safe and sound. I remember sitting in 

this room as Members of this Committee were beating up bankers 

about you are not making enough loans, you are not making any 

money available to people. And the reaction of the bankers was: 

Are you kidding? What we have just been through where we were 

beaten up for being too open in making money available to people 

who went out and lost it? You are darn right we are not making 

any loans because the regulators will kill us if we do. We are 

threatening safety and soundness if we make loans. 

You are now in an atmosphere very similar to that atmosphere 

where the populist reaction to things is shut everybody down, and 

my only concern is that if we overreact and do shut everybody 

down, we make the recession longer, we hurt the country, and all 

of the rest of it. 

One last quick comment. I understand before I came in you did 

speak about the uptick rule and looking at the locator. You and I 

have had these conversations. I am very grateful to you that you 

have now gone public with our private conversations because I still 

believe the issue of naked short selling is a genuine issue that too 

many people have said for too long does not really exist, and if it 

does, it does not really matter because it is really very small. And 

to those investors who have seen their companies destroyed as a 

result of it, it is a big deal. 

Mr. Joseph, did you want to comment on the short-selling thing? 

You looked expectant there, and I did not want to cut you off. 

Mr. JOSEPH. No, I agree, Senator. Naked short selling should be 

curtailed, period, end of story. 

Senator BENNETT. Good. Thank you, Mr. Chairman. 

Chairman DODD. Thank you, Senator Bennett. 

I would note before I turn to Senator Bayh, I think Senator 

Corker raised the issue, we have as well, that sense of balance is 

critical. I have been here as a Member of this Committee—not as 

Chair of the Committee but as a Member of this Committee—during those periods we talk about. And there can be an exuberance 

of the moment, overreactions. Someone once said to me, to pick up 

on your point, why have we done as well as we have? Putting 

aside, obviously, the recent crisis we are in. We are very good. This 

country has been very good, very creative at creating wealth. But, 

second, and as importantly, it has been safe, that if you park your 

resources here, your hard-earned money, that the system and 

structure are safe. You may lose. There is no guarantee of winning. 

But you do not have to worry about your system. It is pretty good. 

We have lost that reputation. And it is striking that balance about 

being creative and imaginative and creating wealth and being safe. 

And it is not always easy to strike that perfect balance that we talk 

about, but that is the goal. If we lose that reputation of being a 

safe place to be because we have a system in place that will not 

allow fraud and deceit and deception to occur, and simultaneously 

to encourage the kind of imagination and thoughtfulness that goes 

into wealth creation is a challenge. Always will be a challenge. We 

are not going to resolve it. I think one of the things—we are raising 

expectations maybe here, that somehow we are going to take care 
30 

of every and all problems that will ever happen again. We are not. 

There is someone out there right now imagining how they can circumvent this system. And the job of this Committee, this Congress, 

and succeeding ones will be to be vigilant as these new ideas 

emerge to make sure they just do not end up in the marketplace 

without someone putting the brakes on and saying: What are you 

doing with this? What does it really do? And what are the implications of it and what risk does it pose? 

I appreciate the Senator from Utah raising that sense of balance. 

It is important. Senator Corker raised it earlier, and I agree with 

him. 

Senator Bayh. 

Senator BAYH. Thank you, Mr. Chairman, and thanks to both of 

you. 

Chairman Schapiro, I have two questions. One we discussed in 

my office prior to your confirmation and it relates to the importance of accurate information for investors making decisions and 

for markets to function, and that implicates the role of the rating 

agencies, which is what I would like to ask you about. With the 

benefit of hindsight, it appears that many of the more exotic instruments were rated too highly. The ratings were not adjusted in a 

timely manner. And some have raised questions about the way in 

which the rating agencies are compensated for making their ratings, paid by the issuers of the securities as opposed to those who 

purchased them or by the government itself. 

I would like to ask you, do you have any thoughts or can we take 

any additional steps to promote accurate ratings of financial instruments so that investors can make decisions in accordance with 

their risk tolerance and not be unpleasantly surprised by buying 

AAA-rated instruments that turn out to be anything but? 

Ms. SCHAPIRO. I think accurate information is absolutely the lifeblood of our markets, and whether it is corporate disclosure or ratings, they are incredibly important to investors. 

The SEC over the last couple of years, since Congress gave it authority in the Credit Rating Reform Act in 2006, has done a number of things to try to bolster the regulatory regime around rating 

agencies. I am not sure that we have gone far enough, and on April 

15, we are actually holding a roundtable to discuss further rating 

agency reform. We will have rating agencies there to talk about 

what went wrong and why. We will have large users of ratings, institutional and other investors to talk about it. And we will have 

people there who are going to talk about some of the more creative 

ideas we have heard about how to change the model of issuer pays 

to try to alleviate some of the conflicts of interest, and there have 

been some very creative ideas expressed. 

So we expect to have a very public day-long session talking about 

all of these issues, the goal of which is to inform the Commission’s 

next steps with respect to either rulemaking or the potential to 

come back and ask the Committee for further legislation. 

Senator BAYH. I would encourage you in this direction. I mean, 

a big part of what we are trying to do now is to reinstall confidence 

in a whole number of ways, and if people simply don’t believe the 

information they are receiving, if they think they are buying instruments that are AAA-rated and they turn out to be anything but 
31 

that, what are they to do going forward in terms of making decisions? It really undermines confidence, and so I look forward to 

getting the benefit of your further input on that. I would really encourage you to focus on that. 

Second, and my final question has to do with, in addition to accurate information making markets function efficiently, incentives 

are important in terms of human behavior. And I think again, with 

the benefit of hindsight, we can see that a lot of the incentives for 

people who are running publicly held companies promoted shortterm decisionmaking and there was a decoupling of the potential 

rewards of running risks and bearing the full consequences of those 

risks, which does lead to skewed decisionmaking, let us just put it 

that way. 

I mean, for example, executives at some firms levered up highly. 

If the thing held together—and they ran significant risks—if it held 

together for just a year or two, they became fabulously wealthy, 

could take some of the chips off the table. And then if the wheels 

came off, well, it was the shareholders who ended up holding the 

bag. So, I mean, there was a decoupling. There was short-term decisionmaking as opposed to long-term decisionmaking and a decoupling of risk and the consequences of running those risks, which 

perverts the kind of decisions that are made. 

So my question to you, in terms of the incentives that exist, what 

can we do to promote long-term decisionmaking and real adding of 

value as opposed to this sort of short-term gambling mentality that 

took hold there for a period of time and has now come back to 

haunt us? 

Ms. SCHAPIRO. I think there are really multiple avenues for us 

to pursue in that regard. One is much better disclosure about how 

risk is tied to compensation. We talked a lot about compensation 

for performance, but noticeably absent has been a real discussion 

about how compensation has been tied to risk taking and the implications of that. 

Senator BAYH. Well, if I could just interject, I mean, it is tied in 

some cases to short-term performance, which then comes back to 

haunt us—— 

Ms. SCHAPIRO. Right. 

Senator BAYH. ——because short-term can fluctuate up and 

down. 

Ms. SCHAPIRO. Exactly right, and risk taking reveals itself over 

the longer run, and so the compensation decisions need to be tied 

to that longer-run perspective. I think, also, we need better disclosure of risk of holding certain financial instruments and just generally better risk disclosure for investors. 

And finally, and the piece we talked about a bit is the ability of 

shareholders to influence more directly who serves on corporate 

boards and tying the responsibility of boards. Board compensation 

clearly resides there, but making boards explain how they closed 

the circle with risk taking and compensation. But giving investors 

greater access to determining who sits on corporate boards is an 

important component of that, as well. 

Senator BAYH. Thank you, Madam Chairman. 

Mr. Joseph, I hope you don’t feel slighted that my time has run 

out, but I thank you for being here, as well. Thank you. 
32 

Chairman DODD. Senator Bayh, thank you very, very much, and 

let me thank both of you. 

Mr. Joseph, let me just tell you, we have got a series of questions 

to submit to you, because obviously what—and some of your proposals raise issues, as well, regarding resources and tools. There is 

a valuable role to be played by the States. In fact, as you point out 

in your opening statement, because you are as close to the investor 

community as you are at that level, it provides an avenue for people to be able to express themselves and bring matters to the public 

attention. So we see a real value in what you do. I think we all 

have some questions about various proposals and raising from 25 

to 100 million and so forth, what that involves. Obviously, the compatibility, as well, between the SEC and the States are very important. 

I regret we didn’t get to spend more time with you, but obviously 

having a Chairperson here obviously focused a lot of attention on 

these current issues before us. So we will submit some questions 

to you and look forward to having you back before the Committee, 

as well. 

Mr. JOSEPH. Thank you, Mr. Chairman. 

Chairman DODD. And Madam Chair, we thank you very much. 

Ms. SCHAPIRO. Thank you. 

Chairman DODD. As you have heard, we have got a lot of interest 

in the subject matter, so we will have you back up formally and 

informally, as well. 

Ms. SCHAPIRO. Thank you. 

Chairman DODD. Let me quickly invite our next panel, and they 

have been very patient and had the benefit of sitting and listening 

to all of this, as well, so they may want to add some addendums 

to their own testimony. 

But I am very honored and pleased to present three witnesses 

who are very familiar with this Committee, have been before us, 

some of us here on the Committee over the years. 

Richard Breeden served as Chairman of the Securities and Exchange Commission between 1989 and 1993. In July of 2002, Mr. 

Breeden was appointed to act as the corporate monitor of 

WorldCom on behalf of the U.S. District Court overseeing the case 

involving history’s largest corporate fraud and largest bankruptcy. 

Arthur Levitt, Junior, is the 25th and longest serving Chairman 

of the SEC, from 1993 to 2001. As Chairman, he created the Office 

of Investor Education and Assistance, established a Web site which 

allowed the public free and easy access to corporate filings and investor education materials. 

Both Chairmen assisted our work, by the way, in SarbanesOxley, going back, and I know both these individuals very, very 

well. If you needed to have examples, if you wanted to just say, 

give me an example of good public servants, I offer up the names 

of Arthur Levitt and Richard Breeden and a look at their work 

would define, I think, what has been remarkable public service, 

and successful in the private world, as well. So you bring a wonderful wealth of experience from both sides of the equation. You heard 

Senator Bennett use the word ‘‘balance’’ and others talk about how 

we strike those balances of wealth creation and having safe and 

sound financial institutions and a regulatory process. 
33 

Paul Atkins is the former Commissioner of the Securities and 

Exchange Commission. He served from 2002 to 2008, and we thank 

you very much, as well, for joining us and we thank you for your 

service on the Commission during those years. 

I guess we begin on a seniority basis here. By seniority, I guess 

you were the earliest serving, Mr. Breeden, so unless you have 

worked out something else, we will begin with you and then move 

right down the line. Thank you all very much, and thank you for 

your patience in listening to the first panel. 

STATEMENT OF RICHARD C. BREEDEN, FORMER CHAIRMAN, 

SECURITIES AND EXCHANGE COMMISSION 

Mr. BREEDEN. Thank you very much, Chairman Dodd, Ranking 

Member Shelby, and Members of the Committee, for the opportunity to offer my views on enhancing investor protection and improving financial regulation. These are really, really critical subjects and it is a great pleasure to have a chance to be back before 

this important Committee. 

I was privileged to serve as SEC Chairman from 1989 to 1993. 

My views here today reflect that experience at the SEC as well as 

my White House service in 1989, when we had to craft legislation 

to deal with an earlier banking crisis, that involving the savings 

and loans. In subsequent years, my firm has worked on the restructuring of many, many companies that encountered financial 

difficulties, most notably WorldCom in the 2002 to 2005 range. 

Today, I am an investor and my fund manages approximately $1.5 

billion in equity investments in the United States and Europe on 

behalf of some of the Nation’s largest pension plans. 

By any conceivable yardstick, our Nation’s financial regulatory 

programs have not worked adequately to protect our economy, our 

investors, or our taxpayers. In little more than a year, U.S. equities 

have lost more than $7 trillion in value. Investors in financial firms 

that either failed or needed a government rescue have alone lost 

about $1 trillion in equity. These are colossal losses without any 

precedent since the Great Depression. 

After the greatest investor losses in history, I believe passionately that we need to refocus and rededicate ourselves to putting 

investor interests at the top of the public policy priority list. We 

have badly shattered investor confidence at a time when we have 

never needed private savings and capital formation more. There is 

much work to be done to restore trust, and I must say, in the public policy debates, we seem to worry endlessly about the banks that 

created this mess and I believe we need to focus a little more on 

the investors who are key for the future to get us out of it. 

Many people today are pointing at gaps in the regulatory structure, including systemic regulatory authority. But the Fed has always worried about systemic risk. I remember back in the Bush 

task force back in 1982 to 1985, the Fed talking about its role as 

the lender of last resort and that it worried about systemic risk. 

And they have been doing that and we still had a global banking 

crisis. 

The problems like the housing bubble, the massive leverage in 

the banks, the shaky lending practices and subprime mortgages, 

those things weren’t hidden. They were in plain sight, except for 
34 

the swaps market, where I agree with the previous witnesses that 

there is a need for extending oversight and jurisdiction. But for the 

most part, the banking and securities regulators did have tools to 

address many of the abusive practices but often didn’t use their 

powers forcefully enough. 

Creating a systemic or super-regulator, in my view, is a giant 

camel’s nose under the tent. It is a big, big step toward industrial 

planning, toward central planning of the economy, and I think the 

very first thing that creating a systemic regulator will do is to create systemic risk. I fear very much that if you are not extremely 

helpful, we will have more ‘‘too big to fail,’’ more moral hazard, and 

more bailouts, and that is not a healthy path for us to move forward. 

I am very concerned that we not shift the burden of running regulated businesses in a sound and healthy manner from management and the boards of directors that are supposed to do that. Unfortunately, in the wake of this crisis, we have seen boards of directors that failed miserably to control risk taking, excessive leverage, 

compensation without correlation to performance, misleading accounting and disclosure, overstated asset values, failure to perform 

due diligence before giant acquisitions. These and other factors are 

things that boards are supposed to control. But over and over again 

in the big failures, the boards at AIG, Fannie Mae, Lehman Brothers, CitiGroup, Bank of America, Wachovia, WAMU, in those cases, 

boards were not doing an adequate job. 

So my view is that we need to step back as part of this process 

and look and say, why are boards not doing what we need them 

to do? I think one of the important answers is that we have too 

much entrenchment of board members, too many staggered boards, 

too many super voting shares, too many self-perpetuating nominating committees, and a very, very high cost to run a proxy contest to try and replace directors who are not doing their jobs. 

So I think one of the important things that Congress can look at, 

and I hope you will look at in the future, is to enact a shareholder 

voting rights and proxy access act that would deal with proxy access, uninstructed votes by brokers, which is corporate ballot stuffing, majority vote for all directors every year, one share, one vote. 

There are a number of things where if we give a little more democracy to corporate shareholders, we can bring a little more discipline 

to misbehavior in corporations and not put quite so much on the 

idea that some super uber-regulator somewhere is going to save us 

from all these problems. 

Thank you very much. 

Chairman DODD. Thank you. 

Mr. Levitt. 

STATEMENT OF ARTHUR LEVITT, FORMER CHAIRMAN, 

SECURITIES AND EXCHANGE COMMISSION 

Mr. LEVITT. Thank you, Chairman Dodd and Ranking Member 

Shelby, for the opportunity to appear before the Committee this 

morning. Thank you for your kind words. It is good to be back with 

former friends and colleagues. 

When I last appeared before this Committee, I focused my remarks on the main causes of the crisis we are in and the signifi-
35 

cant role played by deregulation. Today, I would like to focus on 

the prime victim of deregulation, investors. Their confidence in fair, 

open, and efficient markets has been badly damaged, and not surprisingly, our markets have suffered. 

Above all the issues you now face, whether it is public fury over 

bonus payments or the excesses of companies receiving taxpayer 

assistance, there is none more important than investor confidence. 

The public may demand that you act over some momentary scandal, but you mustn’t give in to bouts of populist activism. Your goal 

is to serve the public not by reacting to public anger, but by focusing on a system of regulation which treats all market actors the 

same under the law, without regard to their position or their status. 

Many are suggesting we should reimpose Glass-Steagall rules. 

For six decades, those rules kept the Nation’s commercial banks 

away from the kinds of risky activities of investment banks. While 

it would be impossible to turn back the clock and reimpose GlassSteagall, I think we can borrow from some of the principles and 

apply them to today’s environment. The principles ensured are regulation’s need to match the market action. Entities engaged in 

trading securities should be regulated as securities firms, while entities taking deposits and holding loans to maturity should be regulated as depository banks. Regulation, I think, is not one-size-fitsall. 

Accounting standards must be consistent. The mere mention of 

accounting can make the mind wander, but accounting is the foundation of our financial system. Under no circumstances should accounting standards be changed to suit the momentary needs of 

market participants. This is why mark-to-the-market accounting 

should not be suspended under any condition. 

The proper role of a securities regulator is to be the guardian of 

capital markets. Of course, there is an inherent tension at times 

between securities regulators and banking supervisors. But under 

no circumstances should securities regulators, especially those at 

the SEC, be subordinated. You must fund them appropriately, give 

them the legal tools they need, and hold them accountable to enforce the laws you write. 

And finally, all such reforms are best done in a complementary, 

systemic way. You can’t do regulation piecemeal. 

Allow me to illustrate how these principles can be put to work 

in specific regulatory and policy reforms. First, some have suggested that you create a super-regulator. I suggest you take a diverse approach using the existing strengths of our existing regulatory agencies. For example, the Federal Reserve is a banking supervisor. It has a deep and ingrained culture that is oriented toward the safety and soundness of our banking system. 

Ultimately, the only solution to the tension is to live with it. 

when I was at the SEC, there was tension between banking regulators and securities regulators all the time. While this was frustrating for the regulators and the financial institutions themselves, 

I think it served the overall purposes of reducing systemic risk. 

Regulatory overlap is not only inevitable, I think it may be desirable. 
36 

Second, mark-to-the-market or fair value standards should not be 

suspended. Any effort that seeks to shield investors from understanding risk profiles of individual banks would, I believe, be a 

mistake and contribute greatly to systemic risk. The Chairman of 

the Federal Reserve, the heads of the major accounting firms maintain that maintenance of mark-to-the-market standards is essential. 

Third, this Committee and other policymakers seek to mitigate 

systemic risk. I suggest promoting transparency and information 

discovery across multiple markets, specifically credit rating agencies, municipal bond issuers, and hedge funds. For years, credit 

rating agencies have been able to use legal defenses to keep the 

SEC from inspecting their operations even though they dispense investment advice and sit at a critical nexus of financial information 

and risk. In addition, these rating agencies operate with significant 

protections from private rights of actions. These protections need to 

be reconsidered. 

In the same manner, the SEC should have a far greater role in 

regulating the municipal bond market, which consists of State and 

local government securities. Since the New York City crisis of 1975, 

this market has grown to a size and complexity few anticipated. It 

is a ticking time bomb. The amount of corruption, the amount of 

abuse, the amount of pain caused to municipal workers and will be 

caused to municipal workers in an environment that is almost totally unregulated is a national scandal. 

Because of the Tower amendment, many participants, insurers, 

rating agencies, financial advisors, underwriters, hedge funds, 

money managers, and even some issuers have abused the protection granted by Congress from SEC regulation. Through multiple 

scandals and investment debacles hurting taxpayers, we know selfregulation by bankers and brokers through the Municipal Services 

Rulemaking Board simple does not work. We must level the playing field between the corporate and municipal markets, address all 

the risks to the financial system. 

In addition, I would also recommend amending the Investment 

Advisers Act to give the SEC the right to oversee specific areas of 

the hedge fund industry and other pockets of shadow markets. 

These steps would require over-the-counter derivatives market reform, the outcome of which would be the regulation by the SEC of 

all credit and securities derivatives. To make this regulation possible and efficient, it would make sense, as my predecessor, Chairman Breeden, has said so often, to combine the resources and responsibilities of the SEC and CFTC. Under no condition should the 

SEC lose any of its current regulatory authority. The Commission 

is the best friend investors have. 

The resulting regulatory structure would be flexible, effective in 

identifying potential systemic risk and supportive of financial innovations and investor choices. Most importantly, these measures 

would help restore investor confidence by making sure rules are enforced equally and investors are protected from fraud and outright 

abuse. 

As we have seen in the debate over mark-to-market accounting 

rules, there will be strong critics of a strong and consistent regulatory structure, but someone must think of the greater good. That 
37 

is why this Committee must draw on its heritage of setting aside 

partisanship and the concerns of those with single interests and affirm the rights of investors whose confidence will determine the 

health of our markets, our economy, and ultimately our Nation. 

Thank you. 

Chairman DODD. Thank you very much, Mr. Levitt. We thank 

you for being here. 

Mr. Atkins, we welcome you to the Committee. 

STATEMENT OF PAUL S. ATKINS, FORMER COMMISSIONER, 

SECURITIES AND EXCHANGE COMMISSION 

Mr. ATKINS. Thank you very much, Chairman Dodd, Ranking 

Member Shelby, and Members of the Committee, for inviting me 

here today to the hearing. It is a great honor for me to be here 

today, and especially appearing today with two great public servants whom I know very well and admire. 

This Committee has had a long history of careful study and analysis of matters relating to the financial markets and the financial 

services industry, and as you have already heard in your hearings, 

there are multiple, complex, and interrelated causes to the current 

situation in global financial markets. I believe that these causes 

are more than the competence or incompetence of individuals in 

particular roles, but have more to do with fundamental principles 

of organizational behavior and incentives. 

Your topic for today is rather broad, so I would like to touch on 

a few specific items that go to the heart of an agency that I know 

very well, the Securities and Exchange Commission. 

With respect to the subject of regulatory reform—— 

Chairman DODD. Mr. Atkins, can you pull that microphone a little closer to you? 

Mr. ATKINS. I am sorry. 

Chairman DODD. Thank you very much. I appreciate it. 

Mr. ATKINS. With respect to the subject of regulatory reform, 

your hearings have so far been a very good start and I would suggest that you ask some very hard questions in subsequent hearings. For example, why was the SEC in the course of the last dozen 

years or so has the SEC experienced such catastrophic failures in 

basically every one of its four competencies—rulemaking, filing review, enforcement, and examinations? What led to the failures of 

the SEC and other regulatory agencies, both in the United States 

and globally, to discern the increasing risk to financial institutions 

under their jurisdiction? What led the failures at financial institutions to recognize the inadequacy of their own risk management 

systems and strategy in time to avert a collapse? How did so many 

investors get lulled into complacency and not adequately do their 

own due diligence? What is the proper role of credit rating agencies, and has regulation, in fact, fostered an oligopoly by recognizing the opinions of a few as being more privileged than those of 

the rest? 

These are hard questions, and if there are to be changes to the 

Federal securities laws, I think they need to be made carefully 

through a robust analysis of the costs and benefits of various potential actions and how those actions might affect human behavior 

in the market. 
38 

The current situation is certainly no time to wing it or to act on 

gut instincts because investors ultimately pay for regulation. And 

if Congress doesn’t get it right, severe consequences could be in 

store for the U.S. Once on the books, laws, especially in this area, 

seem to be very hard to change and unintended consequences live 

on. 

Prior to the recent crisis, the subject of regulatory balance was 

being discussed. Senator Schumer, Mayor Bloomberg, the U.S. 

Chamber of Commerce, and others cited many reasons why the 

U.S. as a marketplace was not so competitive. In fact, in 2006, the 

value of Rule 144A unregistered offerings in the U.S. for the first 

time exceeded that of public offerings. 2006 seems like a long time 

ago, but it still is very much a valid concern, especially once the 

global financial system recovers. 

The worrisome thing to me is that if care is not taken to have 

solid analysis, the wrong lessons may be gleaned from this latest 

crisis and that will ultimately hurt investors. It takes a long time, 

as I said, to change legislation in this area. So what we need is an 

analysis to determine how we can effectively and efficiently promote honesty and transparency in our markets and ensure that 

criminality is not tolerated. 

For example, I disagree with the assertion that deregulation in 

the past four, eight, ten, or what have you years has led to the current problems in the financial markets. One can hardly say that 

the past eight to 10 years have been deregulatory with the adoption of new laws and rules, such as Sarbanes-Oxley. More regulation for regulation’s sake is not the answer What we need is smarter regulation. 

The global crisis has primarily affected regulated versus nonregulated entities all around the world, not just in the supposedly 

deregulatory United States. The question is, how did so many regulators around the world operating under vastly different regimes 

with differing powers and differing requirements all get it wrong? 

Indeed, how did so many firms with some of the best minds in the 

business get it wrong? 

During the past dozen years, the SEC has experienced catastrophic operational failures in its four core functions of filing review, rulemaking, enforcement, and examinations. ENRON’s corporate filings were not reviewed for years in the 1990s. Tips were 

not pursued regarding Bernie Madoff and regarding the late trading of mutual funds in 2003. It took literally an Act of Congress 

led by this Committee to get transparency and a reformed SEC 

process with respect to credit rating agencies. 

These mistakes, I think, were a long time in the making and 

were caused by failures of the system of senior staff management. 

First, management applied faulty motivational and review criteria, 

and second, since resources are always limited, there is an opportunity cost in choosing to spend time and resources on one thing 

because then, of course, there is less time and less resources to 

spend on other things. 

With respect to opportunity costs, I believe that the SEC, especially in the years 2003 to 2005, was distracted by controversial, divisive rulemaking that lacked any grounding in cost-benefit analysis during this very crucial period right when many instruments, 
39 

like CDOs and CDSs, took off and established their trajectory. Because these rules and the arguments for them were ultimately invalidated by the courts after both long litigation and much distraction for the agency and the industry, a lot of essential time was 

wasted. 

Because life is full of choices, if you devote resources to one 

thing, you have less to devote to another, and the one risk that you 

haven’t focused on just may blow up in your face. That is, in fact, 

exactly what happened to the SEC, and it was really through back 

office processes and documentation that weren’t attended to that 

led to the current crisis. 

There are other things that I would be happy to talk about that 

I put into my written testimony. With respect to that, I have mentioned in my written testimony an article on enforcement and the 

processes at SEC. I ask that I be able to submit that for the record. 

Chairman DODD. Consider that done. That will be certainly true 

of both Mr. Breeden and Mr. Levitt, as well, any additional comments and thoughts. 

And obviously, I have already had conversations with Richard 

Breeden and Arthur Levitt and I expect I will have a lot more in 

the coming weeks, and we invite, Senator Shelby and I and Members of the Committee, as we work our way through this, and we 

are very conscious, both Senator Shelby and I are, of the importance of the matter and how well we handle this. So we are very 

interested in getting as much counsel and advice, particularly from 

people who have been through this and been around over the years 

to watch a lot of what is occurring. 

Let me ask you, if I can, to start out with, to get the panel’s 

views on two proposals from the current administration, the proposal to establish a resolution authority of nonbank institutions. 

And I would also like to ask you to comment on the public–private 

plan to purchase toxic assets. You have all got tremendous experience in this area as well and a little afield. 

The first regarding the resolution authority, and it was the first 

question I raised with Chairwoman Schapiro. Arthur Levitt noted, 

and I quote, that regulation needs to match market action, and 

that if an entity is engaged in trading securities, it should be a regulated securities firm. And that is certainly almost a self-evident 

statement, but nonetheless, deserves being repeated. 

So, obviously, it begs the question, if we are going to have a resolution operation of nonbanks, to what extent, then, are we going to 

involve the agency or agencies that are bringing the most expertise 

and background to the issues so they would have some ability to 

manage that kind of an event? Then, second, what should the role 

of the securities regulator be in the orderly resolution of these securities entities. 

And, then, I would like you to describe, if you could, briefly, what 

features are necessary in the public–private plan to protect taxpayers and restore public confidence in the banking system. It 

seems to me—I think, like many, my general reaction to this, with 

all of its shortcomings, is an idea that I think they needed to pursue. Whether or not this is exactly right or not, I do not know; time 

will tell. But I like the thrust of it, it seems to me, because I hear 

the view that unless you get rid of these assets, this is going to con-
40 

tinue to clog up the system and the credit freeze will continue. And 

then the only answer, seems to me, is to pour capital back in institutions, and we have just run out of patience and resources to do 

that. So you have to try something else to move this along. 

While there are questions, legitimately, about what valuation 

will be on these, whether or not sellers will sell, buyers will buy, 

it seems not trying to do something like this is a far greater mistake, in my view, than trying something. 

So at least my general reaction is a positive one. That does not 

mean I am buying into every dotted I and crossed T, but I would 

be very interested, given all your background and experience, to 

comment on that as well. 

So, Richard, do you want to start? 

Mr. BREEDEN. Yes, sir. Let me start with the resolution question. 

There is an old saying that you cannot really have Christianity 

without the devil, and capitalism does not work if you do not have 

failures. I mean, we have a competitive system, and some people 

win and some people lose. And if we close the door—one of the 

things that has traditionally been one of the greatest strengths of 

the U.S. economy has been Chapter 11 and our willingness to let 

companies fail and then restructure them. 

I went through the largest one in history of this country, 

WorldCom, where we took a company that had $35 billion a year 

in revenues, 75,000 employees, a mere $85 billion worth of missing 

assets, and all kinds of problems, a catalog longer than anybody 

could dream of, and over a 3-year period, we restructured it. It 

came out of bankruptcy with 66,000 employees still there, the business in tact. And what it was worth when it went down, probably 

three or 400 million, was eventually sold for 12 billion, and creditors came out with a very good recovery. If you can fix WorldCom, 

you can fix anything. 

Our problem in the financial space—so I think when you talk 

about nonfinancial institutions, airlines, car companies, whatever, 

bankruptcy is there. It is a good workable structure. And we have 

a problem that we seem to have policymakers who either do not 

understand it or are afraid to use it. And that is why we have the 

courts and they can restructure companies; it is a very, very good 

thing. 

In the financial world, we have been afraid to use it. And one of 

the thing I suggested in my testimony was that Congress think 

about something like the national securities surveillance courts you 

have created, over in the terrorism side; create a court composed 

of senior judges who have actually handled big, multi-billion dollar 

collapses and restructuring, and have expedited processes so that 

an AIG could—that there would be a structure to handle it. 

Throwing it into bureaucracies, whether it is the Treasury or the 

Fed, to me is the wrong approach because you are going to get ad 

hoc decisions. And, frankly, part of the reason we had so much 

panic in the market, loss of confidence, last fall was that every 

Sunday night you would get out of the blue a decision coming out 

of one of the administrative agencies about how they were handling 

Fannie Mae and Freddie Mac, Bear Stearns, Lehman Brothers and 

so on. And every one of them was different. There was no consistency. 
41 

One of them preferred stock to be wiped out, the next one to be 

protected. One of them the debt is OK; the next one, it would be 

wiped out. And there was no real way to predict it. And when investors cannot predict what is going to happen, then you are not 

going to lend credit because you cannot make a sensible decision. 

So I think the rule of law is a very, very healthy thing in the 

resolution area. And creating a court aimed at handling large financial institution failures, with lots of input from the Fed and the 

Treasury and SEC, but where it is done in a judicial context, would 

be very helpful. 

Mr. Chairman, we had failure of Drexel Burnham when I was at 

SEC, and we also had a restructuring of Solomon Brothers, two of 

the largest securities firms of the time. 

Drexel had a regulated broker-dealer and its holding company 

was off doing everything under the sun. When they got in trouble, 

we seized the broker-dealer, we sold it to PaineWebber, and we 

took the unregulated holding company and we sent them down to 

the local bankruptcy court. And they spent the next three to 4 

years sorting it out, and it was just fine. The market was not interrupted in any way. 

The same technique could have been used at AIG. You could 

have taken the regulated insurance companies, sold them to other 

companies instead of sitting there with them, and put the unregulated activities, swaps or anything else, put them into a bankruptcy 

proceeding and wind them down. And that would be a much better 

mechanism for dealing with all the issues that come along. 

So I think the topic of having a resolution mechanism that works 

for a big financial institution is a good topic, but I would urge that 

we spend a little more time looking at the range of alternatives 

rather than just throwing them into the Treasury Department, 

where I am not sure they have the institutional knowledge to make 

good decisions. 

Chairman DODD. Let me jump—Arthur Levitt and Mr. Atkins, 

quickly, on this subject matter. 

Mr. LEVITT. Generally speaking, I associate myself with Richard’s views, although in this case, because of the nature of the crisis is so different than it was at the time of Drexel Burnham or 

elsewhere, morphing over into economic Darwinism I think is a 

mistake. 

We are operating in a polarized environment, highly polarized. 

And because of that, the notion of these public–private partnerships will be met with a measure of skepticism in terms of what 

the government may extract once more from any private sector entity that wants to deal with the bureaucracy. 

I agree that the approach has to be more comprehensive, less at 

the edges, more directly, in terms of determining who is going to 

make it and who is not going to make it. And the notion of adding 

bureaucratic layers of control and judgment and dispensation I 

think will slow the process and slow the eventual outcome. 

Chairman DODD. Let me just ask you—because, Richard, you 

were one of the architects of the Resolution Trust Corporation in 

the 1980s. And there, there was—being a bit of a devil’s advocate. 

Certainly your approach is interesting, but there, there was the 
42 

creation and it did work. We did not get everything back, but we 

got a lot back, and your idea had great value and merit. 

Given Arthur’s point here, this is arguably a time when the tentacles are far more far reaching in many ways. The issues are not 

sort of stovepiped, not that they were then either, but nonetheless. 

Is that a change of view? If you had to go back to the 1980s, 

would you be sitting here offering something different than what 

you suggested at the time? 

Mr. BREEDEN. Thank you, Mr. Chairman. I have thought a lot 

about our experiences, creating the RTC and dealing with the savings and loan crisis as I have watched the current crisis unfold. 

In a nutshell, our philosophy back then was no bailouts but fast 

funerals, and it worked pretty darn well. 

Chairman DODD. That is an Irish expression. 

Mr. BREEDEN. It worked pretty darn well. 

There is similarity in the public–private partnership, that the 

Treasury is trying to establish for the troubled assets, and the 

RTC. RTC was an entity that just stripped all the assets out of everything that failed and then repackaged them and tried to sell 

them back out to the market as quickly as you possibly can. These 

assets do not get better when they are owned by the government; 

get them back in private hands where they can be managed effectively. 

I think that is what Treasury’s public–private partnership is trying to do without creating an agency, if you will, to do it. And I 

think it will work. They are on the right path. I have not looked 

at all the details of it. It is critical that you have price exposure, 

that you let people bid on these packages, that they not be directed 

to individual purchasers. It is important that you have transparency. And the key to all of it is that—and the big difference between the current plan is we were dealing with debt institutions. 

They were closed, and then we took the assets out and repackaged 

them. 

Chairman DODD. Right. 

Mr. BREEDEN. So they did not care what price they got because 

they were not in existence anymore. We, on the other hand, would 

sell assets to maximize recovery for the taxpayers, and we got a lot 

of it back. 

The whole—this plan, one of the critical issues will be, at what 

price will a bank, that is still doing business, that is carrying stuff 

on its books at 60, that maybe is worth 15, are they going to be 

willing to sell it into one of these public–private partnerships—— 

Chairman DODD. I agree. 

Mr. BREEDEN. ——that is at a realistic price. 

Mr. LEVITT. That is absolutely critical. And in a globalized electronic market, the margin of error is so much narrower than it has 

ever been in the history of commerce. A mistake now is measured 

in milliseconds. 

Chairman DODD. Right. But let me ask—I mean, I agree with 

that. And I am going to turn to Senator Shelby. 

I agree with that. I think it is a very good point, not Madoff 

enough. Everyone is wondering whether there will be buyers. I 

think the issue is whether or not there will be sellers. That is really going to be the issue, will you sell. 
43 

I am just imagining this. And, again, I am just listening to some 

folks, and we have a panel coming up who can maybe shed some 

more light on this. 

My guess is if you are a board of a bank, and you are sitting 

there, and someone is saying, we think this thing is worth more 

than what they are offering, my reaction might be, you know what, 

get rid of this stuff; let’s move along. The credit markets are not 

going to open up until we get this unclogged. And while you may 

be right, and I am sure it is worth more than what they are offering here, let’s move along. 

I have to believe that thinking may have some influence on the 

decision of sellers to move the product along. I know it affects balance sheets, though. But the larger good here is, get this moving. 

So I do not know whether that is going to be the case or not, but 

that is the counter argument I have heard about whether or not 

sellers will sell. 

I do not mean to dwell on all of this, but it is an interesting 

point. 

Let me turn to Senator Shelby. I have taken way too much time. 

Senator SHELBY. Thank you. 

Mr. Breeden, you were chairman of the SEC from 1989 to 1993. 

Mr. Levitt, you were chairman of the SEC from 1993 to 2001. We 

know Mr. Atkins was a commissioner there for some 8 years, I believe it was. 

In looking back at your time at the SEC, what could each of you 

have done differently that would have helped to prevent the roots 

of the current crisis from growing? 

Mr. Breeden? You were there a while back, I know that. 

Mr. BREEDEN. We did everything we could, and I suppose you 

can always do more—— 

Senator SHELBY. Sure. 

Mr. BREEDEN. ——to maintain market discipline. I have a deep 

faith that continues to this very day, that markets do a better job 

disciplining risk than bureaucrats do. So I did not want the SEC 

trying to figure out if Drexel Burnham would say—should stay in 

business or not. I wanted the market to decide that. 

We tried to draw the line and make clear that too big to fail did 

not include the securities industry; that if you extended credit to 

a securities firm, do it on the basis of their creditworthiness because we were not going to bail you out if you got it wrong. 

I wish we had established that principle more clearly, because to 

the extent that anybody out there thought Lehman Brothers or 

Bear Sterns were inside a taxpayer protection umbrella that would 

have allowed them to borrow more money, get more credit than 

their own balance sheet warranted—and I think we get into so 

many problems of distortion in the marketplace. You saw it with 

Fannie and Freddie, you see it with any area where you have 

moral hazard where people are thinking, well, I can lend money 

here because if it goes wrong, taxpayers, the government, will 

somehow step in and bail it out. 

We did the right things when I was there to try and make sure 

we drew the line and said, in the securities industry, you are on 

your own, but I suppose we could have done it better. 

Senator SHELBY. Mr. Levitt. 
44 

Mr. LEVITT. A day does not go by when I do not think about this 

very question. The first mistake I made was not pressing harder 

for an immediate resolution of the issue of expensing stock options. 

We are now entering a decade or transparency, where every rule, 

every regulation, every judgment will be judged by the metric of 

how transparent it is. That was a case in point. 

Second was maybe the most important issue of all. There came 

a time when the chairwoman of the CFTC came to the President’s 

Working Group and said, it is time to regulate swaps. Alan Greenspan, Bob Rubin and others said, that is impossible. You cannot do 

it. We have trillions of dollars of outstanding contracts. It is the 

wrong thing to do; do not do it. 

I went along with it. I went along with it without taking the additional step of saying, wait a second. Maybe we have those contracts out there. Let’s grandfather them, and going forward, let’s 

regulate them, mandate them to go on an exchange, give them 

transparency. I did not call for a mandated central clearing facility, 

and that was a mistake that I will regret as long as I think about 

these things. 

Senator SHELBY. But there is nothing like transparency in anything, is there? 

Mr. LEVITT. Absolutely. 

Senator SHELBY. And confidence to bring trust back to the market. 

Mr. LEVITT. Essential. 

Senator SHELBY. Essential. 

Mr. Atkins. 

Mr. ATKINS. Thank you, Senator Shelby. You know that commissioners can be literally the fifth wheel at the SEC, but—— 

Senator SHELBY. But you are part of the system. 

Mr. ATKINS. Definitely, and I tried to ring the gong down 

through the years. 

I think one thing is that the SEC probably became a little bit too 

focused on the equity markets and, to a lesser extent, the options 

markets, and did not pay enough attention to the debt side, including as Chairman Levitt was just talking about, munis. And the real 

question is do the equity markets still function as the primary 

price discovery mechanism because a lot of that has shifted to the 

debt side. So I think there needs to be new types of skill sets at 

the SEC. 

Second was maybe not speaking out more loudly and often about 

some of the backoffice and documentation issues for CDOs and the 

CDSs down through the years. 

Then, finally, with respect to the enforcement program at the 

SEC, I think what has happened over the years is that the senior 

staff has tendeding to chase headlines rather than to look at real 

cases that hurt real investors, Ponzi schemes and stock manipulations, really disparaging them as ‘‘slip and fall’’—or unimportant— 

cases. 

Senator SHELBY. Mr. Breeden, you know, as well as everybody 

does, the Federal Reserve is not only the central bank but it is the 

regulator of our holding companies, our largest banks. I believe myself that they have utterly failed as a regulator, utterly, because 

most of our Wall Street banks that got in trouble, and some of 
45 

them are in trouble today, still, were regulated by the Federal Reserve. So that causes me great heartburn when we start talking 

about the Federal Reserve as the systemic risk regulator, you 

know, the all powerful thing. 

Explain your concerns about having the Fed serve in the role as 

a systemic regulator. 

Mr. BREEDEN. Well, Senator, I think this is a terribly important 

subject, and I really hope people stop and think about this. The 

Fed does, as lender of last resort—and I hope we will always have 

a central bank, not the world’s largest hedge fund, over at the Federal Reserve. But as lender of last resort, well, you can only cram 

so many—every time the Fed buys everybody else’s broken assets, 

you are not really fixing those assets, you are just moving them 

over to the Federal Reserve. And there are limits to how you do 

that. 

Senator SHELBY. They seem to be keeping a lot of them too long. 

Mr. BREEDEN. Well, they do not get more valuable as you hold 

them. 

Senator SHELBY. I know. 

Mr. BREEDEN. So this lender of last resort role has always given 

the Fed a stature and an importance in the system, and it is quite 

genuine; central banks do play a critical role. But their primary 

role is, of course, monetary policies, stability of the currency, and 

you will always pick Fed chairmen and Fed Governors to get good 

economists who will do that role well. 

Regulation is kind of off on the side. Who really runs regulation 

in the Fed, I am not sure anybody ever really knows. 

Senator SHELBY. Maybe they did not have anybody running it. 

Mr. BREEDEN. Well, bottom line, there is probably $800 billion in 

equity losses at Citicorp, B of A, WaMu, Wachovia, all institutions, 

which, as you point out, were regulated by the Fed. 

So the idea that we are now going to add to their plate GE and 

IBM and General Motors and every other—United Technologies, 

and anybody else who makes something important—well, they 

make elevators, and elevators is certainly systemically important; 

we cannot get around without them. Who knows what ends up in 

that—— 

Chairman DODD. Just be careful of the names you use here, you 

are throwing out. 

Mr. BREEDEN. Well, I thought you might notice, Mr. Chairman. 

So I worry you are creeping very far into industrial policy. And 

I go back to my comment earlier. You cannot stop everybody from 

failing. You have to have a mechanism where the people who were 

unsuccessful get taken over and replaced by people who are successful. 

So the farther we go into saying the Fed will oversee everybody 

big in the economy—their expertise is looking at banks, not other 

kinds of firms. So you are putting people who do not have the experience and do not have the expertise in charge of regulating people, 

and you will get bad regulation. You will have the illusion of regulation, but maybe not the successful outcome. 

Senator SHELBY. You said their expertise was looking at banks. 

Now, that is very debatable today—— 

Mr. BREEDEN. At best. 
46 

Senator SHELBY. ——because if they are the regulators I said 

earlier, and they are, of our holding companies, and our banks, so 

many of our big banks failed under their supervision, that says a 

lot to me about the Fed’s inadequacies. 

Thank you, Mr. Chairman. 

Chairman DODD. Thank you very much. 

Senator Warner. 

Senator WARNER. Thank you, Mr. Chairman. I think Senator 

Shelby asked a very good question in terms of what mistakes were 

made, and I appreciate the candor of the witnesses. 

I do think that one of the things Mr. Atkins said that struck 

home to me, as somebody who has been around the markets for 

some time, is over the last 10, 15-plus years, the enormous focus 

on the equity side as opposed to the debt side. And as the debt side 

got more and more complicated, I think it even got, perhaps, less 

focused. So I think a very valid point. 

Following up on the chairman’s comment as well, about whether 

we are going to have willing sellers, I do think there is—and I 

know you have had these meetings, Senator Shelby. Senator Corker has had these meetings as well where you have got the hedge 

fund community saying everything is melting down and the banks 

saying, no, we are actually fine. Maybe the stress test will give us, 

if they are applied with some rigor, some winnowing out process 

and push those who fall below into this sales procedure. 

I have just got word that the Budget Committee is, which I am 

on, is in the markup. So let me just ask a question and not be able 

to stay for the answer. But I would like to start with Chairman 

Levitt, I guess. 

Earlier, we had Chairman Schapiro in, and we were asking about 

say on pay. I would be curious to have you and your colleagues’ 

comments on say on pay. And I would also love to hear just your 

more general comments. Nobody thinks we are going to unscramble 

the eggs post-Glass-Steagall, but I would like your comments about 

what should be some of the underlying principles. 

Should we acknowledge that all institutions are going to be able 

to do all things on a going-forward basis, and what challenges and 

opportunities does that present us in terms of a new regulatory 

structure? 

Again, my apologies to the Members that I have to go down and 

vote in this markup. 

Thank you, Mr. Chairman. 

Chairman DODD. Thank you very much, Senator Warner. 

Senator Corker. 

Senator WARNER. There was a question there, Mr. Chairman. 

Senator SHELBY. Oh. I see. I thought you were walking out, so 

I apologize. 

Mr. LEVITT. With respect to say on pay, what I would say about 

this, this sounds like an easy call. How can you be against it? And 

I am not. But I think it is simplistic. It can be a check the box kind 

of mentality, which businesses can easily incorporate and just move 

on. 

I urge any legislation to allocate to the SEC the responsibility of 

defining exactly what that means under what circumstances, how 

it is done, how far down it goes, what the details should be, what 
47 

the explanation should be, what the history should be. Not simply 

pass a rule because, I assure you, it looks differently than if you 

refine it in a way that I think the Commission should be charged 

with doing. 

Mr. BREEDEN. Just on say on pay, real briefly, I am chairman of 

the Board of H&R Block, and we put say on pay in voluntarily last 

year. It works fine. It is good to let shareholders express their 

views. If they do not like your pay policies, then you ought to find 

out about it sooner rather than later. And we did the same thing 

at Zale Corporation, where I am on the board. We put it in voluntarily. I think the American business community has been resisting 

something that is simple, easy and an appropriate step to take. 

I share Arthur’s concern that say on pay alone is not going to fix 

our compensation problems. You really have to have some ability— 

if compensation committees do outrageous things—and we have all 

seen examples of profligate compensation that can get seriously out 

of whack. You have to go beyond that and have either majority voting every year where shareholders can try and withhold votes or 

voting against members of a compensation committee. And, ultimately, you have to have the threat that if boards do not do a good 

job managing compensation policy, that they could be replaced. 

And until you do that, an advisory vote that just every year says 

you are doing a terrible job is not going to solve the problem. 

Chairman DODD. Yes. Well said. 

Mr. ATKINS. With respect to say on pay, I am an advocate for federalism. I think that Congress needs to be, or should be, a little bit 

leery of wading into this issue. We do not have a Federal corporate 

code or anything like that. I think once you start wading into it, 

the question becomes, where do you stop? And, maybe Congress 

should concentrate, like you did in Sarbanes-Oxley, on empowering 

the SROs, the stock exchanges and others, and then maybe leave 

it to the states to do what they deem appropriate—states acting 

and the shareholders acting within the ambit of the state laws and 

regulations as best suits the individual situation. 

Chairman DODD. Senator Corker. 

Senator CORKER. Thank you, Mr. Chairman. I think this testimony you all have given I think has been outstanding this morning. 

I could not agree more with you, Mr. Breeden, about the boards. 

I think there is a lot of reforms that need to take place to strengthen boards’ responsibility to oversee and to give, I think, shareholders some powers that they now do not have. We have had numbers of conversations regarding that. I could not agree more. 

Mr. Levitt, it is amazing to me, this fascination where somehow 

another changing accounting rule actually changes the status of an 

entity. While I do think there should be some degree of judgment, 

which I know the SEC ruled upon, anyway, several months ago— 

it has not had the uptick from the public accounting entities yet. 

But I think your comments are right-on. And it is amazing to me 

that people would think that an accounting rule would actually 

change the actual status of an entity, but I thank you for that. 

Then, Mr. Chairman, I do think the seller issue you talked about 

is real. I think the securities will fly out the door because they 

have already been marked to market, and people sort of know 
48 

what—they have marked them down realistically. I think on the 

whole loans or the assets, we are going to have a serious problem. 

And I think that piece has got to be worked through. And, certainly, if those assets are sold below where they are—of course, 

there is a different set of accounting standards that go there. We 

are talking about, in combination with the stress test, additional 

capital going into these entities, right? And it could be coordinated 

in a way that I think could be very helpful. 

But let me go back to Mr. Breeden. You mentioned having this 

special court to deal with some of these complex entities. And then 

on the other hand, there is the whole issue of protecting citizens 

for those that are not ready to go into that. So a resolution entity 

of some kind may be necessary, even if you had a structure for entities to move into Chapter 11. 

Is that true or false? 

Mr. BREEDEN. Senator, I would say if you had the right Chapter 

11 mechanism, you would not need an intermediate step. Companies would operate as long as they could get the liquidity and the 

credit to operate. If they got to a point where they could not, bang, 

you would make a filing that—like Chapter 11 does, you stop the 

ability of people to shut an entity down while it goes through this 

reorganization process. 

So I do not think you would need an agency as a sort of warming 

tent for a special court. I think if you did it right, that court would 

be able to do things earlier. And one of the problems with Chapter 

11 and financial institutions is it is loaded under current law toward liquidation, and that is what I think you have got to fix. 

Mr. LEVITT. I would like to add one point to that, and it goes to 

the general tone of all of this testimony. Whether we have a court, 

whether we have a resolution, whether we have new rules, and 

whether we have a systemic regulator, do not under any circumstances allow that to diminish the investor protections offered 

by the SEC. The consequence of that kind of action, no matter how 

nice it sounds, not matter how pretty its dressing may look, would 

be to turn that agency into a Betty Crocker kind of agency, which 

does nice things for investors, but has no bite, has no power, has 

no authority. It just stands up there as an empty symbol. That is 

the danger of creating these systems of oversight and systemic risk 

and whatever it is that you call it. Do not allow investors to be 

hurt by this process. 

Senator CORKER. Thank you very much. Let me move on. This 

economic Darwinism that Mr. Levitt referred to earlier, we see— 

I think we are going to have a task force report on the automotive 

industry that is going to come out, and they are going to lay out 

what futuristic things need to occur. 

Does the fact that debtor in possession financing is difficult to 

get today, does that in any way affect your view of economic Darwinism, if you will? 

Mr. BREEDEN. Senator, I—— 

Senator CORKER. Meaning that if somebody goes into Chapter 

11—under the WorldCom scenario, you had the ability to finance 

assets that were of value. There are people that I think would 

argue very strongly, and probably have a great point as we see 

what is happening, that there is not financing available for that 
49 

kind of thing. Does that in any way affect your thoughts on entities 

like that? 

Mr. BREEDEN. Senator, I think you have put your finger on a terribly important issue, the availability of debtor in possession financing, and that is an area where a resolution authority might be 

able to—finding liquidity for those facilities, particularly if you suddenly need a giant one to deal with an AIG or something of that 

magnitude, would be an area that could conceivably be very helpful 

in working out with the Federal Reserve what form of public–private financing, if we are having inadequate liquidity in debtor in 

possession financing, Because without that, reorganization does not 

work. 

You know, Arthur was being a little critical of my economic Darwinism, but I am really unrepentant on that. If companies fail, you 

need to let them fail, and you need to let them be replaced by people who do a better job of managing. It does not mean that they 

will disappear from the face of the Earth. What we call Bank of 

America today really was once North Carolina National Bank. And 

a lot of other banks failed, and they got put together, and it grew 

and grew. 

Well, you can put these institutions together by acquisitions, and 

you can also take them apart by divesting things, making them 

smaller and more manageable, and arguably you sometimes make 

companies a lot better and a lot more valuable when they get back 

to a more manageable focus and size. 

So you do need the DIP financing. That is a critical role—— 

Senator CORKER. So you would advocate then potentially, instead 

of all the activism that we have had through Treasury and TARP 

and certainly now a Treasury Secretary, it appears, who wants to 

codify TARP, you would actually argue instead that we consider as 

a body creating a debt in possession financing mechanism that 

would allow people to go into an orderly Chapter 11 and have the 

ability to finance out in lieu of that. Is that what you are arguing? 

Mr. BREEDEN. You have done a better job than I could of articulating that, but I think that coupled with having the ultimate decisions not made by a Cabinet Secretary but made by somebody 

wearing a black robe, I think having the courts be involved—because then you have the ability to deal with contracts for bonuses 

and to deal with the fact that the entity has more obligations than 

it has money to pay for them. And so they all need to be restructured, and doing that through the rule of law rather than every 

Sunday night somebody in an administrative agency makes a decision and announces it, if it stuns the market, I really like the protections as an investor. I like the protection knowing if I make an 

investment, what rights do I have, and who is going to back them 

up, and that that is going to be done through the judicial system 

ultimately. 

So I would marry up your suggestion of a DIP financing facility, 

if you will, with the judicial oversight, and I think we would then 

have something that would be very workable. 

Senator CORKER. Mr. Chairman, I know my time is up. I want 

to say that Mr. Breeden’s opening comments to me were pretty 

clairvoyant and somewhat chilling in light of what we see happening. We have this Trojan horse. You know, it looks really pretty 
50 

and it sounds really pretty, and I am talking about the systemic 

regulator being an entity. 

Chairman DODD. That is not going to happen. 

Senator CORKER. I know that you, for what it is worth, have 

looked at—I know you talked with Susan Collins the other day 

about something she has put forth. I have to tell you, based on 

what I sense and feel, I think it would be one of the worst mistakes 

we could possibly make to put in one person’s hands that ability. 

I do think very quickly we would move into industrial policy issues, 

things way beyond—I mean, we will never define properly systemic 

risk. I mean, it could move into all kinds of things, like WorldCom 

or other things. 

I thank you for pursuing that route. I see Senator Shelby nodding. But I hope we will resist any move—any move—that gives 

anybody that kind of power and basically renders almost every 

other entity in Government useless. 

Chairman DODD. One of the things we learned, going back in 

Richard Breeden’s day, is that you cannot have the regulator in a 

sense also be responsible for the resolution of these matters. What 

I said the other day is an entity that only talks to itself is dangerous in a sense when you get to these matters. And so that is 

why I, for one—again, I want to make it clear as well. I have not 

written anything, I have not—I am just listening, as we all are, to 

these various ideas and what make sense. And I like Richard 

Breeden’s idea of this one, whether or not you can do this kind of 

a thing, but I agree with him the notion of getting—so you get resolution. I mean, the whole idea of calling it resolution is to get to 

a resolution on these matters. 

Mr. BREEDEN. Absolutely, Mr. Chairman. 

Chairman DODD. And so we need to think carefully how we do 

it, but I agree with you, Senator, that this has got to be one that 

is thought out and has balance to it. These are complicated institutions today, either by design or acquiescence, and so, therefore, to 

look at them and how you unwind requires a lot more eyes on this 

than would come from one single entity. The danger of doing that 

seems to me to only complicate the problem to some degree. So I 

think we sort of agree on that. 

I just want to make—and we have got to go to that. Jack Reed 

has shown up who has done a terrific job as the Chairman of the 

subcommittee on Securities, and I invoked your name earlier without your permission, and that is, there is a lot of interest in Chairman Schapiro’s testimony today and suggested that maybe the subcommittee would continue, formally or informally, following up the 

conversations with the SEC. 

I wanted to mention a subject matter, and just because it has 

come to my attention, and that is, this resetting or repricing of options. I have been reading some stories about how, obviously, with 

the decline in the price of various stocks, where options were taken 

on them, on the assumption, of course, their value would continue 

to increase—and it has done exactly the opposite. But whether or 

not certain people at a certain level are resetting the option at the 

lower price at the expense of shareholders who do not have that 

same ability raises some serious issues, in my view. And I was 

going to raise it with Jack, may draft a letter, in fact, to the SEC 
51 

and others to find out what is going on with this. Again, I am reading news reports about it, so I want to be careful about suggesting 

something is absolutely the case. But, nonetheless, it is disturbing 

to me that that may be happening. And so we may want to look 

at that. We will draft something along those lines and get some answers very quickly. 

I do not know if you have seen anything like that. I do not know 

if either of our witnesses have seen any reports on the resetting of 

options at a certain level. Have you seen this as well? 

Mr. LEVITT. Through the years, this is part of the compensation 

issue, and it is something—— 

Chairman DODD. Well, it is huge. You go from something that 

was $100 and it moves to $5 or $10 more, that is value. If you are 

going from $100 down to $10 and all of a sudden that stock goes 

to $20, and you have reset it at $10 for a handful of people, that 

makes some of these other issues pale by comparison. 

Mr. LEVITT. Some companies have set and reset and reset and 

reset and reset again. 

Chairman DODD. Well, I do not know how my colleagues feel, but 

it is something we ought to look at. 

Senator SHELBY. Absolutely. 

Mr. BREEDEN. Mr. Chairman, it is another area where having 

large shareholders being able to be on the board—I guarantee that 

in companies where our fund sits on the board of directors, there 

will be no repricing of options. And, you know, shareholders are the 

ones who are hurt by that because nobody repriced for us the cost 

of our shares. And so management, yes, going forward there may 

be new options granted each year at different prices. 

Chairman DODD. That is another matter. 

Mr. BREEDEN. But it is really a terrible abuse when people go 

back and reprice from the past. It was an incentive to make the 

stock worth more, grow value for the shareholders, and really, you 

are jumping off the train and saying I am going to go give myself 

a special deal. That is a very serious problem. 

Chairman DODD. Well, I am hearing sort of—— 

Mr. ATKINS. One note of caution there is that this issue is not 

just a monolithic type of thing. Every company is different. Every 

situation might be different. I think you will probably hear that if 

you write the letter to the SEC. The response will be in various situations, it sometimes might be justifiable and the shareholders 

might have approved it. 

Chairman DODD. Well, again, it is certainly worthy of quick examination because this is the kind of thing that, again, in a week 

or two from now we will pick up our newspapers and discover that 

this has gone on and no one has paid attention to it. It will pale— 

if you think you had a furor over what happened last week, watch 

this one. And so let me just use this forum as an opportunity to 

send a message, before we get a letter written, that someone ought 

to be looking at it immediately, and I would like to hear back what 

steps, if any, are being taken to deal with it. They will respond accordingly, and maybe we will get some people in front of us to talk 

about it. And you are right, there may be different circumstances. 

I am not trying to have a sweeping statement here, but, nonethe-
52 

less, you are hearing from witnesses and others, this is troubling, 

to put it mildly. So we will take a look at it. 

Anyway, we are going to keep the questions open. We could have 

you here virtually all day, the three of you, and it is so valuable. 

I cannot thank you enough for appearing this morning, and we will 

submit some additional questions. There is an awful lot to ask you. 

We are just doing the securities field. There are a number of 

issues. I appreciate, by the way, Arthur, your comment on the 

muni issue, the bond issue. This is very important. Your language 

was very strong. In our private conversations, you have expressed 

this to me as well. And certainly this Committee will take a look 

at it, a completely very unregulated area and one that poses some 

real risks, and I appreciate you bringing that point up. 

Mr. LEVITT. Thank you. 

Chairman DODD. With that, this panel will be excused, and we 

thank you for coming. 

I am going to introduce the next panel, and I am going to thank 

them for their testimony in advance. I want to thank Jack Reed for 

his willingness to chair. I am not going to be here for all of this. 

I will be here for a few minutes of it, anyway, but let me begin and 

I will introduce them. 

Richard Ketchum is the Chairman and CEO of FINRA. He is 

also Chairman of the World Federation of the Exchanges’ Regulatory Committee. 

Ronald Stack has served on the Municipal Securities Rulemaking 

Board since 2006 and is Managing Director of Barclays Capital, 

with responsibility for the firm’s national public sector investment 

banking effort. 

Richard Baker is President and Chief Executive Officer of the 

Managed Funds Association, a former colleague of ours, served in 

the other body, previously a member of the U.S.—as I mentioned, 

a member of the House of Representatives, Chairman of the subcommittee on Capital Markets for 12 years. 

Jim Chanos is Chairman of the Coalition of Private Investment 

Companies. Mr. Chanos is also President of Kynikos Associates, a 

New York private investment management company. 

Barbara Roper is the Director of Investment Protection for the 

Consumer Federation of America. 

David Tittsworth is the Executive Director and Executive Vice 

President of the Investment Adviser Association. 

Dan Curry is the President of DBRS’ U.S. affiliate. Previously he 

spent 22 years at Moody’s Investor Service. 

And Rita Bolger, our last witness, is the Senior Vice President 

of Global Regulatory Affairs, Associate General Counsel for Standard & Poor’s, and has served as the head of Global Regulatory Affairs. 

Senator SHELBY. Mr. Chairman, can I say something? 

Chairman DODD. Yes, you certainly may. Let me thank all of 

you, and we are packing you in here. I apologize. I hope you found 

this morning interesting. At least you have been sitting here and 

listening to the Chairmen of the Securities and Exchange Commission and then our last panel, so I am sure you would have been 

paying very close attention had you not been asked to be here. But 

having you in the room, I kept on looking out to see how you were 
53 

reacting to some of the things that were being said. I saw some 

commonality of interest being expressed on certain matters and 

some dismay at others, I guess, along the way. So I was watching 

the nodding heads along the process. 

Let me turn to Senator Shelby for some comments quickly, and 

then we will get to our panel and ask you to share some thoughts 

with us on the subject matter before us. 

Senator SHELBY. Mr. Chairman, I appreciate these hearings that 

you are putting together, and, gosh, we could be here all week and 

learn a heck of a lot. 

I have reviewed this testimony of the third panel. A very, very 

impressive panel. A lot of you I know. And all of your testimony 

is interesting. 

Jim Chanos’ testimony I think goes right to the heart of a lot of 

things of what is wrong, and I think we ought to pay particular attention to that. 

The reason I am bringing this up, I, too, have got a luncheon I 

have got to speak at. You know, I am not leaving yet, but I might 

miss some of you. But I want to thank you, like Senator Dodd did, 

for your contribution. And as we go through this trying to find out 

what went wrong and trying to do what should be right in the future, I think we are going to be very careful and very comprehensive. 

Chairman DODD. I thank you for that. Richard Baker, a former 

colleague. You got to be on this side of the dais and now that side 

of the dais. For 12 years you were on this side, so I have gotten 

to know Richard very, very well, and he does a fine job on behalf 

of the people he represents as well. And Jim Chanos I know, and 

like all of us here, many of you we know and worked with in the 

past at various times. So we thank you for coming before us. 

Jack, any opening comments you want to make? 

Senator REED. No. 

Chairman DODD. Well, let us get right to it. Again, we will just 

hear from Mr. Ketchum. We thank you. We will take your full testimony, if you will try and move along. 

STATEMENT OF RICHARD G. KETCHUM, CHAIRMAN AND 

CHIEF EXECUTIVE OFFICER, FINANCIAL INDUSTRY REGULATORY ASSOCIATION 

Mr. KETCHUM. Chairman Dodd, thank you, and it was a morning 

well spent, so it was good to be here. 

Chairman DODD. Thank you. 

Mr. KETCHUM. Chairman Dodd, Ranking Member Shelby, and 

Members of the Committee, I am Richard Ketchum, Chairman and 

CEO of the Financial Industry Regulatory Authority, or FINRA. On 

behalf of FINRA, I would like to thank you for the opportunity to 

testify, and I commend you, Mr. Chairman, for having today’s hearing on the critically important topic of reforming our regulatory 

structure for financial services. 

As someone who has spent the great majority of my career as a 

regulator, dedicated to protecting investors and improving market 

integrity, I am deeply troubled by our system’s recent failures. The 

credit crisis and scandals of the last year have painfully demonstrated how the gaps in our current fragmented regulatory sys-
54 

tem can allow significant activity and misconduct to occur outside 

the view and reach of regulators. FINRA shares this Committee’s 

commitment to identifying these gaps and weaknesses and improving the system for investors. 

Let me briefly talk about FINRA and our regulatory role. 

FINRA regulates the practices of nearly 4,900 securities firms 

and more than 650,000 registered securities representatives. As an 

independent regulatory organization, FINRA provides the first line 

of oversight for broker-dealers. FINRA augments and deepens the 

reach of the Federal securities laws with detailed and enforceable 

ethical rules and a host of comprehensive regulatory oversight programs. We have a robust and comprehensive examination program 

with dedicated resources of more than 1,000 employees. FINRA has 

the ability to bring enforcement actions against firms and their employees who violate the rules. 

Mr. Chairman, as I said earlier, the topic of today’s hearing is 

critical. The failures that have rocked our financial system have 

laid bare the regulatory gaps that must be fixed if investors are to 

have the confidence to re-enter the markets. Our current system of 

financial regulation leads to an environment where investors are 

left without consistent and effective protections when dealing with 

financial professionals. At the very least, our system should require 

that every person who provides financial advice and sells a financial product be licensed and tested for competence, that advertising 

for products not be misleading; that every product marketed to an 

investor is appropriate for that particular investor; and that comprehensive disclosure exists for services and products. 

I would like to highlight the regulatory gap that, in our view, is 

among the most glaring examples of what needs to be addressed— 

the disparity between oversight regimes for broker-dealers and investment advisers. 

The lack of a comprehensive, investor-level examination program 

for investment advisers impacts the level of protection for every 

person that entrusts funds to an adviser. In fact, the Madoff Ponzi 

scheme highlighted what can happen when a regulator like FINRA 

has only free rein to see one side of the business. 

Let me be clear. I mention this example not because FINRA is 

sanguine with its role in the Madoff tragedy. Any regulator who 

had any responsibility for oversight for Madoff must accept accountability and search diligently for lessons learned. But the way 

to identify fraud, just as with sales practice abuse, is not through 

the fog of jurisdictional restrictions. Fragmented regulation provides opportunities to those who would cynically game the system 

to do so at great harm to investors, and it must be changed. 

The regulatory regime for investment advisers should be expanded to include an additional component of oversight by an independent regulatory organization, similar to that which exists for 

broker-dealers. The SEC and State securities regulators play vital 

roles in overseeing both broker-dealers and investment advisers, 

and they should continue to do so. But it is clear that dedicating 

more resources to regular and vigorous examination and day-to-day 

oversight of investment advisers could improve investor protection 

for their customers, just as it has for customers of broker-dealers. 
55 

Broker-dealers are subject to rules established and enforced by 

FINRA that pertain to safety of customer cash and assets, advertising, sales practices, limitations on compensation, and financial 

responsibility. FINRA ensures firms are following the rules with a 

comprehensive exam and enforcement regime. Simply put, FINRA 

believes that the kind of additional protections provided to investors through its model are essential. 

Does that mean FINRA should be given that role for investment 

advisers? That question must ultimately be answered by Congress 

and the SEC, but we do believe FINRA is uniquely positioned from 

a regulatory standpoint to build an oversight program quickly and 

efficiently. 

In FINRA’s view, the best oversight system for investment advisers would be one that is tailored to fit their services and role in 

the market, starting with the requirements that are currently in 

place for advisory activity. Simply exporting in wholesale fashion 

the broker-dealer rulebook or current governance would not make 

sense. 

We stand ready to work with Congress and the SEC to find solutions that fill the gaps in our current regulatory system and create 

a regulatory environment that works properly for all investors. 

Thank you, Mr. Chairman. I would be happy to answer any questions. 

Chairman DODD. Thank you very much, and we will look forward 

to some questions for you, too. 

Mr. Stack. 

STATEMENT OF RONALD A. STACK, CHAIR, MUNICIPAL 

SECURITIES RULEMAKING BOARD 

Mr. STACK. Thank you very much. Good morning, Chairman 

Dodd, Ranking Member Shelby, and Members of the Committee. I 

am Ronald Stack, Chair of the Municipal Securities Rulemaking 

Board. By way of background, I have been involved in the municipal market since 1975 when I was a member of the staff of Governor Hugh Carey during the New York City fiscal crisis. 

I am pleased today to testify on behalf of the MSRB at the Committee’s second hearing on Enhancing Investor Protection and the 

Regulation of the Securities Markets. 

The MSRB was created by the Congress in 1975 to write rules 

for municipal securities dealers, at that time many of whom were 

unregulated, unsupervised, and not even registered by the SEC. 

Our mission was set in statute, and it remains clear and unambiguous, and that is, to protect the investing public and to promote a 

fair and efficient market for municipal securities. This is a $2.7 

trillion municipal market, and it is fundamental to financing our 

Nation’s infrastructure. Indeed, over 55,000 entities issue $400 billion in municipal securities each year. We are absolutely committed 

to preserving municipal access to capital, the municipal market’s 

integrity, and investor protection. This is our mission, this is our 

commitment. 

We believe one of the important ways to protect investors and 

preserve market integrity is through a culture of transparency, one 

that makes information available to all. Historically, access to public disclosure about municipal bonds has been hindered by a se-
56 

verely fragmented disclosure system that was cobbled together over 

the years. This system did not promote public access to disclosure 

documents, and it did nothing to shine a light on the disclosure 

practices of issuers, good or bad. So what have we done? 

The MSRB has developed a comprehensive Web site that is 

transforming municipal disclosure and transparency for all investors, large and small, institutional and retail. It is called the Electronic Municipal Market Access system, which we call it EMMA, 

and it is so advanced that we believe it exceeds disclosure systems 

for any other fixed-income market, and that includes corporate 

bonds. With EMMA, all investors have free access on the Web to 

an incredible amount of information about municipal securities. 

We have had real-time trading information up since 2005. We 

have added official statements and information about auction rates. 

Starting next week, we will add information about variable rates, 

and finally, in July of this year, pursuant to a rule amendment 

that was passed by the SEC in December, we will be including 

what is called ‘‘continuing disclosure filings,’’ which are up-to-date 

material changes from bond issuers. 

Our new system of making continuing disclosure available easily 

and on the Web will be a vast improvement over the current system. EMMA will serve as a red flag for poor disclosure by issuers, 

just as it reveals good disclosure practices. 

But good, timely dissemination of disclosure is only one of our 

myriad responsibilities. We require municipal securities dealers to 

observe the highest professional standards in their dealings with 

investors: full disclosure, suitability, fair pricing. We are the only 

Federal regulator that has successfully implemented a ban on ‘‘pay 

to play.’’ If you are a municipal securities professional, you cannot 

do business with an issuer if you have contributed to one of its officials. We test professionals’ qualifications and we require them to 

take continuing education courses. We have a complete set of rules 

regulating municipal dealers that we constantly review, modify, 

and change as necessary. And I emphasize all of our rules are sent 

out for comment and then are subject to strict review and approval 

by the SEC itself. 

Unfortunately, we continue to read reports—and I think this is 

something which I think Chairman Levitt was referring to—about 

other municipal market participants who engage in ‘‘pay to play’’ 

and similar activities. Some are alleged and some are still under 

investigation, but whatever the outcome, the market suffers from 

an appearance problem, and that is not good for the muni market 

or for any market. 

Earlier this year, we wrote to you and your colleagues in the 

House Financial Services Committee about the potential for regulation of some or all of these other market participants. They serve 

critical roles in many of the complex financing and related derivative transactions that have become commonplace. They advise 

State and local governments, big and small, on how to structure a 

bond issue, how to sell it, how to market it, what type of securities 

to sell, how to invest bond proceeds, whether to use swaps or other 

related derivatives. 

We believe these and other similar market participants should be 

registered with the SEC and regulated by the MSRB with rules 
57 

similar to those already applied to dealers. Many of these people 

are fiduciaries, and they should be subject to the standards of professional conduct. ‘‘Pay to play’’ should be prohibited, just like it 

was prohibited for dealers by the MSRB in 1994. 

I want to emphasize that I know many of these participants, and 

many of the individuals are ethical and well qualified, but, unfortunately, not all of them are and activities of a few can taint the entire market if not by fact, by appearance. That is something we 

cannot afford, especially in the current crisis. 

During this time of stress, it is crucial that we have clear guideposts and that investor confidence in the municipal securities market is not undermined by questionable practices. 

Also, as Treasury seeks to find solutions to assist the municipal 

bond market through the crisis, ensuring that all market participants adhere to the highest professional standards is essential. 

The MSRB looks forward to working with the Committee, as well 

as other regulators and market participants, to ensure that the 

level of investor protection provided in the municipal market is second to none. 

Senators, thank you for inviting the MSRB to participate in this 

very important hearing. 

Chairman DODD. Thank you very much, Mr. Stack. 

Richard Baker, we welcome you to the Committee. 

STATEMENT OF RICHARD BAKER, PRESIDENT AND CHIEF 

EXECUTIVE OFFICER, MANAGED FUNDS ASSOCIATION 

Mr. BAKER. Thank you, Mr. Chairman, Ranking Member Shelby, 

Members. I am indeed delighted to be back after the prohibited period from my engagement with policymakers, and for the record to 

reflect, I did not engage anyone during the prohibited period. It is 

delightful to be here today. 

The MFA represents a majority of the world’s largest hedge 

funds and is the primary advocate for sound business practices for 

industry professionals. We appreciate the opportunity to be invited 

and to comment today about the systemic risk concerns, and we are 

committed to being a constructive participant in the discussion 

going forward. 

Hedge funds do provide liquidity and price discovery to markets, 

capital to companies to allow them to grow or turn their businesses 

around, and sophisticated risk management tools for investors such 

as pensions, to allow them to meet their obligations. 

To perform these market functions, we require sound counterparties and stable market structures. The current lack of certainty regarding financial conditions of major financial institutions has limited the effectiveness of the stabilization efforts, and this uncertainty inhibits investors’ willingness to put their capital at risk or 

transact with these firms. 

The relative size and scope of the industry helps explain why we 

believe hedge funds do not pose significant systemic risk despite 

the current market environment. With an estimated $1.5 trillion 

under management, the hedge fund industry is significantly smaller than the $9.4 million mutual fund industry or the $13.8 trillion 

banking industry. 
58 

Because many hedge funds use little or no leverage, contrary to 

many public comments, their losses did not pose the same potential 

systemic concerns that losses at more highly leveraged institutions 

presented. One recent study found that 26.9 percent of hedge funds 

do not deploy leverage at all, and a recent 2009 report by the FSA, 

the Financial Services Authority, indicated that the leverage of 

hedge funds was, on average, less than 3:1. 

Mr. Chairman, the hedge fund industry was not the root cause 

of the ongoing difficulties in our financial markets, but we have a 

shared interest with all other market participants in re-establishing a sound financial system. To that end, restoration of stability can be accomplished through a careful, deliberate approach 

toward the goal of a smart financial regulatory construct, one 

which would include investor protections as well as a systemic risk 

analysis. 

Smart regulation means improving the overall functioning of the 

financial system through appropriate, effective, and efficient regulation, while encouraging adoption of industry best practices which 

promote efficient capital markets, integrity, investor protections, 

and enabling better monitoring of potential systemic risk events. 

We believe that a single systemic risk organization—and I have 

not been absent during the preceding discussions. I would merely 

want to point out that an organization charge with this responsibility would be better than multiple systemic regulators which 

would likely have difficulty because of jurisdictional conflicts, unintended regulatory gaps, inefficient and costly redundancies. So to 

the extent a regulatory shop can be constructed, it should be a single entity to have that responsibility. 

We do support confidential reporting to that systemic regulatory 

structure by entities the regulator deems to be of systemic relevance any information the regulator deems necessary or advisable 

for it to assess systemic risk potential. It is important for this authority to allow the regulator to be forward-looking and adaptable 

to ever-changing market conditions. It is critical that reported information be granted full protection from public disclosure, which 

we believe can be done without inhibiting the ability of the regulator to protect the overall system. 

In our view, the mandate of this entity should be protection of 

the financial system and not include investor protection or market 

integrity, a role that already exists in the hands of multiple existing regulatory bodies. 

With respect to that mandate, because systemically relevant 

firms likely would not pose the same risk in all circumstances, we 

also believe the regulators should not focus on preventing the failure of a particular firm but, rather, only in the event that firm’s 

failure would be likely to bring about adverse financial system consequences. 

We strongly believe the systemic risk regulator should implement its authority in a way that avoids competitive concerns and 

moral hazards that could result from a firm having an ongoing established Government guarantee against its failure. Therefore, we 

believe a systemic risk regulator would need authority to seek to 

prevent systemic risk in a forward-looking manner, address systemic concerns once they have arisen in the manner it deems ap-
59 

propriate, the ability to ensure that a failing firm does not threaten 

the financial system, and we know that policymakers are also contemplating concurrently a notion of a prudential regulatory framework, including mandatory registration. 

We believe that well-advised regulation should be based on the 

following principles: regulation that is tailored to meet identified 

needs, not nebulous in construct; second, ongoing public–private exchange with notice, comment, and implementation so that appropriate comment may be made on proposed regulatory interventions; 

reporting of appropriate information, which could be left to the regulator, with confidentiality of sensitive and proprietary always 

being protected. Regulatory distinctions to be recognized between 

the various nature of the differing market participants, and encouragement of strong industry practices and robust investor diligence. 

I would like to mention just briefly one other area I know of concern. Short selling facilitates price discovery, mitigates asset bubbles, and increases market liquidity. It is a critical risk management tool for investors which allows them to take long positions in 

the market. There are absolute solutions to address the stated concerns about short-selling that would enable us to continue in our 

current market practices without jeopardizing the important market benefits. 

We look forward to a continued discussion and answering any 

questions you may choose to pose. Thank you, Mr. Chairman. 

Senator REED [presiding]. Thank you, Congressman Baker. 

Mr. Chanos. 

STATEMENT OF JAMES CHANOS, CHAIRMAN, COALITION OF 

PRIVATE INVESTMENT COMPANIES 

Mr. CHANOS. Thank you. Good afternoon, Mr. Chairman, Senator 

Shelby, and Members of the Committee. My name is Jim Chanos. 

I am here today testifying as Chairman of the Coalition of Private 

Investment Companies. I thank you for the opportunity to testify 

on this important subject today. 

The damage done by the collapse of global equity credit and 

asset-backed markets has been staggering in scope. The plain truth 

is that there is not a single market participant, from banker to 

dealer to end user and investor, that does not have to absorb some 

degree of responsibility for the difficulties we are confronting today. 

And while there is plenty of blame to spread around, there is little 

doubt that the root cause of the financial collapse lay at the large 

global diversified investment and commercial banks, insurance 

companies, and government-sponsored enterprises under direct regulatory scrutiny. 

Notably, hedge funds and investors have generally absorbed the 

painful losses of the past year without any government cushion or 

taxpayer assistance. While hedge funds and other types of private 

investment companies were not the primary catalyst for our current situation, it is also true that these private pools of capital 

should not be exempt from the regulatory modernization and improvement that will be developed based on lessons learned from the 

financial calamities of the past 20 months. 

CPIC believes that there are a few key principles that should be 

followed in establishing a regulatory regime for monitoring sys-
60 

temic risk. First, regulatory authority should be based upon activities and not actors. The same activities should be treated similarly, 

regardless of where it takes place. Proprietary trading at a major 

bank should not receive less scrutiny than the trading activity of 

a hedge fund. 

Second, the system should be geared to size, meaning overall size 

or relative importance in a given market and complexity. 

Third, all companies performing systemically important functions, such as credit rating agencies and others, should be included 

in this regime. 

Fourth, accuracy of required disclosures to shareholders and 

counterparties should be considered systemically significant. 

Fifth, the regulatory regime should be able to follow activities at 

systemically important entities regardless of the affiliated business 

unit in which the entity conducts these activities. 

Sixth and finally, the regulatory regime itself should be clear and 

unambiguous about the criteria that brings an entity under the 

new oversight regime. 

Increasing the financial regulation of hedge funds and other private investment companies carries both risks and benefits. I would 

like to chat about that for a few seconds. Relying on the fact of direct regulation in lieu of one’s own due diligence will undermine 

those parts of the private sector that continue to work well and 

thus hamper the goal of restoring market strength and confidence. 

While it is clear that a regulator should have the ability to examine the activities of significant pools of capital to help mitigate 

against activities that would disrupt the markets, simply trying to 

wedge hedge funds and other private investment funds into the Investment Company Act or Investment Advisers Act is not likely to 

achieve that goal. If direct regulation is deemed necessary, Congress should consider a stand-alone statutory authority for the SEC 

or other regulator that permits the Commission to focus on marketwide issues that are relevant to managers of institutional funds 

while not undermining essential investor due diligence. 

Perhaps the most important role that hedge funds play is as investors in our financial system. To that end, CPIC believes that 

maximum attention should be paid to maintaining and increasing 

the transparency and accuracy of financial reporting to shareholders, counterparties, and the market as a whole. Undermining 

accounting standards may provide an illusion of temporary relief, 

but will ultimately result in less market transparency and a much 

longer recovery. 

Private investment companies play important roles in the market 

sufficiency and liquidity. They help provide price discovery, but 

they also play the role of financial detectives. Government actions 

that discourage investors from being skeptical, from being able to 

hear from differing opinions, or to review negative research ultimately harms the market. Indeed, some say that if Madoff Securities had been a public entity, short sellers would have blown a 

market whistle long ago. 

Honesty and fair dealing are at the foundation of investor confidence our markets have enjoyed for so many years. A sustainable 

economic recovery will not occur until investors can again feel certain that their interests come first and foremost with the compa-
61 

nies, asset managers, and others with whom they invest their 

money and until they believe that regulators are effectively safeguarding them against fraud. CPIC is committed to working diligently with this Committee and other policymakers to achieve that 

difficult but necessary goal. 

Thank you very much. 

Senator REED. Thank you very much. 

Ms. Roper. 

STATEMENT OF BARBARA ROPER, DIRECTOR OF INVESTOR 

PROTECTION, CONSUMER FEDERATION OF AMERICA 

Ms. ROPER. Thank you for the opportunity to testify here today 

regarding the steps that the Consumer Federation of America believes are necessary to enhance investor protection and improve 

regulation of the securities market. 

My written testimony describes a dozen different policies in a 

dozen different areas. Out of respect for the length of today’s hearing, I will confine my oral comments to just two of those, bringing 

the shadow banking system within the regulatory structure and reforming credit rating agencies. 

Before I get into the specifics of those issues, however, I would 

like to spend a brief moment discussing the environment in which 

this policy review is taking place. For nearly three decades, regulatory policy in this country has been based on a fundamental belief that market discipline and industry self-interest could be relied 

on to rein in Wall Street excesses. That was the philosophy that 

made the Fed deaf to warnings about unsustainable subprime 

mortgage lending. It was the philosophy that convinced an earlier 

Congress and administration to override efforts to regulate overthe-counter derivatives markets. And it is the philosophy that convinced financial regulators that financial institutions could be relied on to adopt appropriate risk management practices. In short, 

it was this misguided regulatory philosophy that brought about the 

current crisis and it is this philosophy that must change if we are 

to take the steps needed to prevent a recurrence. 

In talking about regulatory reform, many people have focused on 

creation of a Systemic Risk Regulator, and that is something CFA 

supports, although, as others have noted, the devil is in the details. 

We believe it is at least as important, however, to directly address 

the risks that got us into the current crisis in the first place, and 

that includes bringing the shadow banking system within the regulatory structure. 

Overwhelming evidence suggests that a primary use of the shadow banking system, and indeed a major reason for its existence, is 

to allow financial institutions to do indirectly what they would not 

be permitted to do directly in the regulated market. There are numerous examples of this in the recent crisis, including, for example, 

banks holding toxic assets through special purpose entities for 

which they would have had to set aside additional capital had they 

been held on balance sheets, or AIG offering insurance in the form 

of credit default swaps without any of the protections designed to 

ensure their ability to pay claims. 

The main justification for allowing these two systems to operate 

side by side, one regulated and one unregulated, is that sophisti-
62 

cated investors are capable of protecting their own interests. If that 

was true in the past, it is certainly not true today, and the rest of 

us are paying a heavy price for their failure to protect their interests. 

To be credible, therefore, any regulatory reform proposal must 

confront the shadow banking system issue head on. This does not 

mean that all financial activities must be subject to identical regulations, but it does mean that all aspects of the financial system 

must be subject to regulatory scrutiny. 

One focus of that regulation should be on protecting against risk 

that could spill over into the broader economy, but regulation 

should also apply basic principles of transparency, fair dealing, and 

accountability to these activities in recognition of two basic lessons 

of the current crisis: One, protecting investors and consumers contributes to the safety and stability of the financial markets; and 

two, the sheer complexity of modern financial products has made 

former measures of investor sophistication obsolete. 

Complex derivatives and mortgage-backed securities were the 

poison that contaminated the financial system, but it was their 

ability to attract high credit ratings that allowed them to penetrate 

every corner of the market. Given the repeated failure of the credit 

rating agencies in recent years to provide timely warnings of risk, 

it is tempting to conclude, as many have done, that the answer to 

this problem is simply to remove all references to credit ratings 

from our financial regulations. We are not yet prepared to recommend that step. 

Instead, we believe a better approach is found in simultaneously 

reducing, but not eliminating, our reliance on ratings; increasing 

the accountability of ratings agencies, by removing First Amendment protections that are inconsistent with their legally sanctioned 

status; and improving regulatory oversight. 

While we appreciate the steps Congress and this Committee in 

particular took in 2006 to enhance SEC oversight of ratings agencies, we believe the current crisis demands a more comprehensive 

response. 

As I said earlier, these are just two of the issues CFA believes 

deserve Congressional attention as part of a comprehensive reform 

plan. Nonetheless, we believe these two steps would go a long way 

toward reducing systemic risk, particularly combined with additional steps to improve regulatory oversight of systemic risks going 

forward. 

Bold plans are needed to match the scope of the crisis we face. 

CFA looks forward to working with this Commission to craft a reform plan that meets this test and restores investors’ faith both in 

the integrity of our markets and in the effectiveness of our government in protecting their interests. 

Senator REED. Thank you very much. 

Mr. Tittsworth. 

STATEMENT OF DAVID G. TITTSWORTH, EXECUTIVE DIRECTOR AND EXECUTIVE VICE PRESIDENT, INVESTMENT ADVISER ASSOCIATION 

Mr. TITTSWORTH. Thank you, Senator Reed. We really appreciate 

the opportunity to testify today. 
63 

The Investment Adviser Association represents the interests of 

SEC-registered investment advisers. The advisory profession serves 

a wide range of clients, including individuals, trusts, families, as 

well as institutions such as endowments, foundations, charities, 

State and local governments, pension funds, mutual funds, and 

hedge funds. There are about 11,000 SEC-registered advisers. Most 

of these are small businesses. About 7,500 employ ten or fewer employees, and 90 percent employ fewer than 50. 

Our statement outlines our views on broad regulatory reform 

topics, but I am just going to emphasize one point, the need to address true regulatory gaps in two situations. 

First, we continue to support the registration, regulation of hedge 

fund managers by the SEC. We believe that investors and the markets will benefit from the disclosure, compliance protocols, recordkeeping, examinations, and other requirements that accompany 

SEC registration. We also support regulation of credit default 

swaps and other derivatives. Action must be taken to ensure that 

they can no longer exist outside of the regulatory system. 

Our testimony also addresses two issues that directly relate to 

the Investment Advisers Act. The first is the so-called harmonization of broker and adviser regulation. This idea seems to be 

predicated on the notion that brokers and advisers do exactly the 

same thing and that one set of laws and regulations should apply 

to both. We respectfully disagree. 

There are differences between most broker-dealer and most investment advisers. Brokers, or the sell side, typically execute securities transactions and sell financial products. Investment advisers, 

the buy side, provide advisory services, including managing client 

portfolios. Brokers often are compensated by commissions from selling products or executing trades and any related financial advice 

is nondiscretionary, that is, requires customer consent to buy or 

sell. In contrast, advisers generally are compensated by fees and 

provide ongoing discretionary management of client assets. Finally, 

brokers generally have custody of customer assets, whereas most 

investment advisers use the services of independent third-party 

custodians. 

Because of these and other differences, it doesn’t make sense to 

impose rules on investment advisers that are tailored to produce 

sales. 

In recent years, brokers have migrated toward the investment 

advisory business, blurring some of the traditional lines and creating investor confusion. Accordingly, we believe that fiduciary 

standards should apply to anyone who offers investment advice. 

This week, we joined with the State securities organization, 

NASAA, and the Consumer Federation of America in a joint letter 

to the Committee to underscore this very important point. 

The second issue addressed in our testimony is the proposed creation of a self-regulatory organization, or SRO, for investment advisers, which we oppose. Our statement outlines drawbacks to an 

SRO, including inherent conflicts of interest, questions about transparency, accountability, and oversight, and added costs and bureaucracy. We particularly oppose the idea of FINRA as the SRO 

for investment advisers, given its governance structure, costs, track 

record, and its bias favoring the broker-dealer regulatory model. 
64 

In closing, we believe the SEC has the expertise and experience 

to best regulate our profession and it should have appropriate resources to do its job. Instead of creating an SRO for investment advisers, the following alternatives should be pursued. 

First, the SEC should be fully funded and Congress should examine alternatives to allow it to achieve long-term and more stable 

funding, including self-funding mechanisms. 

Second, as NASAA testified, the SEC should increase the $25 

million threshold that separates SEC and State-registered advisers. 

Third, the SEC should improve its inspection program to better 

leverage and focus its resources. 

We would be pleased to work with the Committee and the SEC 

to explore additional ways to ensure the appropriate and effective 

regulation and oversight of investment advisers and I would be 

happy to respond to any questions. Thank you. 

Senator REED. Thank you very much. 

Ms. Bolger. 

STATEMENT OF RITA M. BOLGER, SENIOR VICE PRESIDENT 

AND ASSOCIATE GENERAL COUNSEL, GLOBAL REGULATORY 

AFFAIRS, STANDARD & POOR’S 

Ms. BOLGER. Thank you, and good afternoon—— 

Senator REED. Could you make sure that is on and bring it closer 

to you? 

Ms. BOLGER. Is that better? 

Senator REED. I think so, yes. I am kind of deaf. 

Ms. BOLGER. I would like to state at the outset that we at S&P 

appreciate the seriousness of the current dislocation in the capital 

markets and the challenges it poses for the American and global 

economies. Restoring confidence is critical, and workable solutions 

will involve both governmental action and private initiative. 

S&P has a long tradition of and a strong cultural commitment 

to integrity and professionalism. We recognize, however, that a 

number of our recent ratings in the structured finance area have 

not performed in line with our historical standards. We have reflected on these events and we have made a number of changes to 

enhance our processes. 

Recent calls for increased regulation of credit rating agencies 

have arisen in large part out of the poor performance of structured 

finance securities issued between the middle of 2005 and the middle of 2007, the years in which subprime lending was at its peak. 

From a regulatory perspective, it is important to point out that the 

world in which virtually all of these structured finance ratings 

were issued is not the world that we live and find ourselves in 

today. 

NRSROs, such as S&P, are now subject to a robust regulatory regime. That regime starts with the Credit Rating Agency Reform 

Act, which went into effect in June 2007, and the rules promulgated by the SEC under it. Those rules deal with important topics 

such as resources, potential conflicts of interest, misuse of nonpublic information, and potentially abusive and unfair practices. 

The SEC also has broad enforcement powers over NRSROs. Not 

only does the SEC have extensive examination and inspection authority, but it can take disciplinary action against NRSROs. Those 
65 

include censure, fines, or even revocation of registration if it deems 

such action to be in the interest of investors. 

From my perspective as a participant in the process, the SEC 

has been an extremely active regulator in exercising its oversight 

authority. Last year, the SEC conducted an extensive examination 

of S&P focused on our structured finance ratings. The exam, which 

lasted several months, involved dozens of meetings and interviews, 

production of a significant volume of documents, and resulted in a 

number of recommendations that we are implementing. 

While the current regime has accomplished much in the short 

time it has been in place, we do believe additional measures could 

play a meaningful role in restoring investor confidence. Appropriate regulation can provide a level of comfort to investors that 

policies are being enforced and that there is consistency and integrity in the rating process. 

I also do want to note that we are pleased to be participating in 

the SEC’s April 15 roundtable on rating agencies, which Chairman 

Schapiro referenced this morning. 

We also believe in an end-to-end approach for legislation and regulation. That is, it should be designed to cover all aspects of the 

capital markets that when taken together contribute in a systemic 

way to their functioning, with particular regard to ratings. Such an 

approach would include not just oversight of rating agencies, but 

also appropriate measures for those involved in generating the information that is used in the analysis, the sale and the marketing 

of the rated securities, and the use of ratings. 

For example, an important factor in ratings quality is the quality 

of information available to be analyzed. That information is not 

generated by rating agencies but by others, such as in the RMBS 

area, mortgage originators, and lenders. In our view, oversight of 

these entities and the roles they perform should be part of any regulatory approach. 

As detailed in my written statement, earlier this month, S&P 

published an article reflecting our thoughts on what a regulatory 

framework for rating agencies might look like. I have included a 

copy of that for the record. I would like to highlight here just two 

particular features. 

The first is analytical independence. For the markets to have 

confidence in ratings, they must be made independently. That 

means, of course, that the judgments must be free of conflicts of interest and undue commercial considerations. We are fully committed to that principle. It also means that the judgments must 

truly reflect the substantive views of the analysts making them 

and not directives by a regulator or other external authority. 

The second point is the need for international regulatory consistency. Ratings are issued and used globally. A rating produced 

under one set of regulations may not mean the same thing or address the same risks as one produced under another if those regulations are not compatible. Inconsistent ratings regulation could actually promote uncertainty in the markets at a time when it can 

be least afforded. 

In short, the focus should be on promoting consistency and integrity in the ratings process. Many of the steps we have outlined and 

the measures we have taken are aimed at precisely that goal. 
66 

Thank you for the opportunity to participate in the hearing. Let 

me also assure you again of our commitment to analytical excellence and our desire to continue to work with Congress and all governments worldwide. I would be happy to answer any questions. 

Senator REED. Thank you. 

Before I introduce Mr. Curry, I must excuse myself and Senator 

Akaka will take the gavel and kind of conclude the hearing. Thank 

you, Senator Akaka. Thank you, ladies and gentlemen. 

Mr. Curry. 

STATEMENT OF DANIEL CURRY, PRESIDENT, DBRS, INC. 

Mr. CURRY. Thank you, Senator Reed. Thank you, Senator 

Akaka. Good afternoon. My name is Dan Curry and I am the President of DBRS, Inc. I am pleased to have the opportunity to present 

DBRS’s views on the regulation of credit rating agencies and investor protection, but first, I would like to give you some background 

on our firm. 

DBRS is a Toronto-based credit rating agency established in 

1976 and still owned by its founders. With a U.S. affiliate located 

in New York and Chicago, DBRS is a full-service rating agency 

that maintains ratings on more than 43,000 securities in 35 countries. 

DBRS is committed to ensuring the objectivity and integrity of 

its ratings and the transparency of its operations. DBRS was designated as an NRSRO in 2003, the first non-U.S.-based rating 

agency to attain that designation. DBRS is now registered under 

the Credit Rating Agency Reform Act, which Congress passed in 

2006. 

Now I would like to turn my attention to the important issue of 

competition. It is no secret that the credit rating industry in the 

United States is dominated by three large agencies. The market 

you see today was fostered by a regulatory system that gave special 

treatment to NRSRO credit ratings, yet made the process of attaining that designation opaque and hard to navigate. Although the 

Credit Rating Agency Act has made more competition possible, the 

actual competitive landscape has been slow to change. We believe 

that the continued dominance of the three largest rating agencies 

contributed to the recent turmoil in the structured finance market 

when changes in the assumptions underlying their rating models 

led to rapid and dramatic rating downgrades. 

As the markets struggle to regain their footing, more needs to be 

done to open this industry to competition. Although the government can be a catalyst for change, the opposite seems to be occurring. 

Recognizing that the securitization markets have ceased to function, the Federal Reserve has created the Term Asset-Backed Securities Loan Facility, or TALF. In order to be eligible for this program, the security must receive a AAA rating from Standard and 

Poor’s, Moody’s, or Fitch, which the Fed calls ‘‘major’’ NRSROs. The 

result of this approach is that DBRS, with over 30 years of experience as a rating agency and more than six as an NRSRO, is unable 

to rate TALF-eligible securities, even though several issuers have 

asked it to do so. 
67 

For the foreseeable future, the TALF is likely to be the entire 

securitization market in the United States. Therefore, by excluding 

all but the three largest rating agencies from this program, the 

government may be further entrenching the historic oligopoly for 

years to come. 

The long-term efficiency of the capital markets requires that rating agencies be allowed to compete on the quality of their work, not 

their size or their legacy. DBRS urges Congress to take whatever 

steps are necessary to make the Rating Agency Act’s promise of 

competition a reality. 

The next issue I would like to address is that of uniform regulation. Ensuring that NRSRO regulation treats all business models 

equally is critical to investor protection. This is especially true in 

the area of ratings transparency. There has been much debate 

about the relative accuracy of ratings determined under the issuerpay model and subscriber-pay model. This debate cannot be resolved so long as investors and other market participants are unable to verify the accuracy claims made by subscriber-based ratings 

providers. Anecdotal discussions by these firms of where they got 

it right are no substitute for an objective, independent analysis of 

the universe of their ratings. DBRS urges policymakers and regulators to recognize the importance of transparency for all rating 

agencies. 

Finally, I would like to address the need for stable regulation. 

DBRS sees no need to abandon the regulatory regime established 

under the Rating Agency Act because this regime is barely 18 

months old and no superior alternative has been identified. Moreover, DBRS sees no benefit in transferring jurisdiction over rating 

agencies from the SEC, which has overseen this area for 34 years, 

to a regulator that has no experience. Interposing a self-regulatory 

body between rating agencies and the SEC would be the worst idea 

of all, since this would lead to a duplicative regulation by a costly 

private bureaucracy that may or may not know anything about the 

industry. A better approach would be to ensure that the SEC has 

the necessary resources to effectively examine NRSROs and to enforce the existing laws and rules. 

My written statement addresses some additional issues. I would 

be happy to answer any questions you may have. Thank you. 

Senator AKAKA [presiding]. Thank you very much, Mr. Curry. 

I want to thank all of you for your patience and also to tell you 

that your full statements will be placed in the record. 

I would like to ask my first question to one who has been an advocate, one that I have been with before, and I want to ask Ms. 

Roper as an advocate, as an independent entity within the Internal 

Revenue Service, the National Taxpayer Advocate has evolved into 

an essential organization that has protected and assisted taxpayers. I have highly valued the dedicated efforts of the National 

Taxpayer Advocate and Ms. Nina Olson and her staff. 

Using the Taxpayer Advocate organization as a model and creating an Investor Advocate at the Securities and Exchange Commission has the potential to be an extremely valuable addition to 

assist and protect taxpayers. So my question to you is, what is your 

evaluation of creating an Investor Advocate at the SEC? 
68 

Ms. ROPER. Thank you, Senator. Ideally, it would be superfluous 

to have an Investor Advocate at the SEC. The SEC portrays itself 

as the investor advocate. My experience working on these issues as 

an external investor advocate for over 20 years now is that there 

are many times when we would have benefited from having an advocate on the inside to carry investors’ case. I can see several different areas where I think this would be particularly useful. 

As investor advocates, we have often been frustrated that our 

view is not addressed in the agency policymaking from the outset, 

that it is something that ends up being incorporated, at best, later 

during the comment period, often with very little effect. Having an 

internal advocate who could ensure that investors’ views are integrated into the rulemaking process, conduct research outreach, I 

think would be extraordinarily useful. 

Senator AKAKA. Also, Ms. Roper, we share an interest in protecting mutual fund investors. Mutual funds are what average investors rely on in their retirement, savings for their children’s college education, as well, and other financial goals and their dreams. 

I have advocated for strengthening the independence of mutual 

fund boards and improving relevant and meaningful disclosures for 

investors’ transparency. My question to you is, what must be done 

to better protect and inform mutual fund investors? 

Ms. ROPER. Thank you again, Senator. As you know, we have endorsed your legislation on mutual fund and share those goals. And 

I very much look forward to a time when our primary priorities are 

helping average retail investors make better informed decisions 

and have better protection in the marketplace. That hasn’t been at 

the top of our agenda with the global economy in crisis. But I 

think—and because the damage that has been done to investors 

has been sort of done indirectly through the failure of a system as 

a whole. 

There was a robust mutual fund reform agenda that was put on 

the table at the SEC in the wake of the mutual fund trading scandals and then was allowed to sort of fall by the wayside. I think 

it would be extraordinarily useful to bring back some of the ideas 

that were under discussion at that time, including better point of 

recommendation disclosures, independence governance, as you have 

suggested, and not just limited to mutual funds, but the entire 

issue of broker-dealer compensation and how that creates a set of 

incentives that operate against investor interest, I think, are extraordinarily important issues that it would be nice to be able to 

get back to at some point in the near future. 

Senator AKAKA. Thank you for your responses. 

I would like to ask the next question to Mr. Richard Ketchum. 

Our modern complex economy depends on the ability of the consumers to make informed financial decisions, and as you know, we 

have been supporting trying to move financial literacy in our country. Without sufficient understanding of economics and personal finance, individuals will not be able to appropriately evaluate credit 

opportunities, successfully invest for long-term financial goals, or 

be able to manage difficult financial situations. My question to you 

is, what must be done to ensure that investors have the knowledge 

and skills necessary to make informed investment decisions? 

Mr. KETCHUM. Well, thank you, Senator. It is a great question. 
69 

Senator AKAKA. Before you do that, let me say that FINRA has 

been doing a good job already, and I know that. Thank you. 

Mr. KETCHUM. Well, I appreciate that. As you know, the FINRA 

Investor Education Foundation is the largest foundation solely focused on investor education, and given that we both feel good about 

the progress we have made and recognize the enormity of the task, 

we have tried to, as best we can, both through placing a rich series 

of informative efforts on our Web site at finra.org and efforts to try 

to attract investors to look at those various different pieces of information, efforts to identify everything from questions to ask with respect to complex products to things to be concerned about with respect to potential scams, as well working very closely with some of 

the most vulnerable constituencies, particularly from the standpoint of our seniors, our military, et cetera. 

I think the only answer with respect to investor education is to 

keep on going on with more and more resources and more and 

more cooperation between enterprises that have constituencies and 

concern with respect to this area. And you are right. It can’t just 

be with respect to investors that exist today. It has to be a strong 

effort from the standpoint of our schools, as well. 

But we are very much committed to be part of that process. It 

is something that deserves more attention from a governmental 

standpoint and more attention across any of us that cares deeply 

about the quality of our securities markets. 

Senator AKAKA. Thank you very much for that. 

I want to pose this next question to a person that I knew in the 

House, Representative Baker. I think you left there, or you were 

there when I left there, in the House and moved to the Senate. But 

it is good to see you again. 

Mr. BAKER. Thank you, Senator. 

Senator AKAKA. Chairman Breeden said, and I am quoting, ‘‘The 

disasters we have seen did not arise due to lack of resources for 

the Federal Reserve, the SEC, or any other agencies that did not 

perform as well as needed to do, or because of outdated laws from 

the 1930s.’’ 

The banking and securities regulators generally had tools to address the abuse of practices but did not use their powers forcefully 

enough or ask for new authority promptly when they needed it. 

My question to you, how would you recommend addressing this 

problem so that the regulators will be more effective in the future? 

Mr. BAKER. Thank you, Senator. It is a tremendously difficult 

question in that if you would go back in time, perhaps 24 months, 

and look at market conditions and the tremendous profitability 

that had existed for some number of years, and the expectation by 

many that it would continue into the foreseeable future, there was 

at the same time columns of regulatory authority that were constructed. 

Within each column, there may have been particular skill sets 

which could have been deployed, but because of the lack of information flows between those columns, complex instruments were created that did not fit neatly within a column and remained outside 

the transparency required for someone to make an informed decision. 
70 

I would say that there were people in the market who exercised 

analytical skills and who did, in fact, predict that some of these 

very unfortunate circumstances possibly would occur. They, for the 

most part, were in the private sector, who were skilled analysts 

looking at the financial bubble that was growing in significant size. 

How we could construct a new systemic regulatory structure and 

enable a single person to be able to see the entire view of the market and come to an appropriate and timely decision would probably 

be almost impossible. Having an organization of some sort—there 

has been discussion this morning as to concerns about the SEC, the 

Federal Reserve, the existing entities. But I think we should be 

cognizant of the fact that none of those entities had access to the 

level of transparency that would have enabled them to make that 

collective, almost omniscient, insight into the coming storm. 

So I believe that, as we suggested in our testimony, the construction of a regulatory entity—I have been very careful not to say a 

particular agency—that has access to market information in a 

timely manner, while at the same time protecting the privacy of 

that disclosure by the registered entity, would perhaps—I am not 

sure it would guarantee—enable that entity to be able to take steps 

early on and perhaps limit the scale and scope of damage. 

Certainly, we would like to be a participant in that discussion 

going forward. We have specific ideas at the appropriate time that 

may be appropriate to consider. But we recognize that it is a very 

difficult problem. I am glad you are where you are, Senator, and 

I am glad I do not have that decision any longer. 

Senator AKAKA. Thank you very much, Representative Baker. 

I want to direct my next question to Mr. Stack. 

In our last hearing on securities regulation, Thomas Doe, a 

former member of your board, stated, and I am quoting, that ‘‘the 

34-year era of the municipal industry self-regulation must come to 

an end.’’ 

In advocating this position, Mr. Doe emphasized that MSRB 

structure, two-thirds of which is comprised of either bank dealers 

or securities dealers, has led to a situation of industry capture, 

where the issuers and other writers are then responsible for regulating their own conduct. 

What is your evaluation of these comments? 

Mr. STACK. Senator, I take extreme exception to Thomas Doe’s 

comments. I believe that the MSRB, which was the first SRO upgrade in 1975, has worked extraordinarily well. 

The measure of an SRO, such as the MSRB, is, first, do we protect investors? How we do that is through our ability to ensure immediate and clear disclosure to both retail, institutional, small and 

large investors. We have established a new electronic system on 

the Web to ensure up-to-date investor information. 

We also regulate, up to the extent that the statute allows, very 

clearly all of the municipal dealers and brokers in very strong 

terms. For example, we are the only group that prohibits a pay to 

play; that is, that you cannot do municipal securities financings 

with an issuer if you contribute to somebody running for office who 

is an official of that issuer. No one else has done that. Interestingly 

enough, because we are an SRO, we can do something even tougher 
71 

than what we call our parent body, the SEC, because we have the 

ability to set very, very strong rules. 

Another thing I would like to say is that all of our rules governing our brokers and their dealers are sent out for comment to 

the public, to investors, to everybody around, and then we present 

our proposed rules to the SEC. So it is not that we are off in the 

ether land, just kind of somewhere out there making our own rules 

for brokers. All of our rules go to the SEC for review, and the SEC 

decides whether or not to approve them. 

Finally, some of the problems I mentioned in my testimony that 

we have encountered are that there are many participants in our 

market who right now are unregulated: financial advisors, swap 

advisors, investment advisors. They are not registered with the 

SEC, and we have no power to regulate them. 

We have written the House Committee and have written your 

Committee and asked for the ability—asked for Federal regulation 

of these groups in order that they can have professional standards, 

in order that they can meet the kind of stringent requirements that 

we have for brokers and dealers, including and specifically pay to 

play. We think if we can regulate those participants, that the market will operate well. 

In conclusion, we believe the SRO system does work well and it 

is a way of using the expertise of the market participants to come 

up with rules to govern it. I have read the Senate Committee report when the MSRB was set up in 1975, and that was the Committee’s intent. These rules, as I say, can be tougher, and then 

those rules are submitted to the SEC. And the SEC then approves 

whether or not those rules go into effect. 

So we think that the SRO is actually a very tough way to organize and to supervise dealers. The SEC is not limited, but it sticks 

pretty much to antifraud issues. We can go much further and pay 

to play is a perfect example of where we have. 

Senator AKAKA. Well, I thank you so much for that. You know 

of it personally. I would rather that we not craft laws just to try 

to deal with these. In this particular case, the MSRB should just 

move—as you said, what you mentioned, I wish we could do at this 

time. But thank you so much for your comments on that. 

Mr. STACK. Thank you, Senator. 

Senator AKAKA. Let me direct the next question to Mr. 

Tittsworth, and is Chanos or Chanos? 

Mr. CHANOS. Chanos, Senator. 

Senator AKAKA. Chanos. Thank you. 

And I am looking for an important recommendation, so I would 

like to hear from both of you. 

Which is one recommendation that you feel is the most important 

legislative or regulatory initiative that this Committee must undertake in the modernization of financial market regulation? 

Mr. TITTSWORTH. I will take it very quickly, Senator. 

As I said at the top of our testimony, it is closing what I would 

call true regulatory gaps, not the perceived regulatory gap that 

some have talked about between investment advisers and brokerdealers, which is totally nonexistent. True regulatory gaps. And by 

that, I mean products or services that are unregulated and are out-
72 

side the regulatory system. And the two I mentioned are hedge 

fund managers and credit default swaps and derivatives. 

Senator AKAKA. Thank you very much. 

Any other comment? 

Mr. CHANOS. Senator, I would use my answer to just point out 

our overriding viewpoint on regulation, current and future. And 

that is that the current and expected regulatory framework regulates and examines the activities, not the actors. That is, they focus 

on that which is going on in the marketplace across different corporate and private and public investment lines, and not just be 

hamstrung, for example, for the Fed to look at bank holding companies; the SEC to look at securities firms. 

We need to really focus on how our markets have changed down 

through the years and have morphed beyond the view of the 33 and 

34 and 40 acts, and come up with smart regulation as someone 

said earlier, not necessarily more regulation. 

Senator AKAKA. Thank you very much. 

I wanted to be certain that we would offer every one of you a 

chance to make comments, so let me direct this question to Ms. 

Bolger and Mr. Curry. 

The Wall Street Journal reported that despite the failure of ratings agencies’ models during this financial crisis, Moody’s, S&P and 

Fitch have ‘‘made few fundamental changes to the way they assess 

debt.’’ 

Please tell us what you think went wrong in your original assessment of these assets and why we should trust your agencies to rate 

these same assets again, now that taxpayer money is at risk. 

Ms. BOLGER. Thank you, Senator. And, actually, before answering, I would respectfully request that the white paper on regulation, I mentioned it in my remarks, that that be placed in the 

record. Thank you. 

Ms. BOLGER. I think certainly in terms of some of the ratings and 

structured finance, just stepping back, we have almost a hundred 

year history of rating a tremendous amount of securities and a very 

good track record. But in connection with some of those securities, 

I think the performance that we have seen, that the market has 

seen, has not been consistent with that historical track record. 

Some of the assumptions that we use simply were not borne out. 

However, we have stepped back. We have taken a very serious 

look at our processes and we have made a number of changes, 

changes both that have been required in connection with two, now 

two—and, actually, today is the conclusion of a final draft period 

for SEC rulemaking, so we have made changes in connection with 

their requirements. 

We have also made some changes on our own initiative. And we 

think moving forward, it is important, again, picking up on the 

theme of smart regulation, that we focus on regulation that preserves our analytical independence and also that is globally consistent in connection with some of these actions we have taken. 

Senator AKAKA. Thank you. 

Mr. Curry. 

Mr. CURRY. Thank you, Senator. 

I think that the root of the problem in the structured securities 

was the reliance on the decisions of just a few people using models 
73 

to determine these ratings. At the same time, the securities became 

so complex that investors were really unable to exercise enough 

judgment around the risks that they were taking. And we are going 

through the flip side of that process, I think, right now, where 

there are some very substantial changes to assumptions, again, in 

these models made by a few people, that lead to massive rating 

downgrades, but still a lack of understanding of fundamentally 

what is behind this analysis. 

Given that the current Rating Agency Reform Act does not extend to the substance of ratings, I think that transparency becomes 

very critical, and that is going to be a big challenge in how that 

is managed. I still do not think that the transparency is adequate 

and I worry that a lot of the changes that have taken place are 

more administrative and do not really prevent us from ending up 

in this same situation again seven or 8 years down the road. 

Senator AKAKA. Thank you very much, Mr. Curry. 

Without question, all of you have been very helpful to the Committee. We are looking forward to improve whatever needs that in 

our Nation. I want to thank all the witnesses for being here. And 

I want you to know that we appreciate the significant time that 

you witnesses have spent with us today. 

This hearing record compiled today will, without question, help 

us develop policies to better protect investors and improve the regulation of the securities market. We look forward to continuing to 

hear from you, and with much hope, we are looking at an improvement in our Nation’s crisis that we are in at this time. 

This hearing record will remain open for a week for Members to 

submit any additional statements or questions that they may have. 

Again, thank you very much, and this hearing is adjourned. 

[Whereupon, at 1:35 p.m., the hearing was adjourned.] 

[Prepared statements and response to written questions supplied 

for the record follow:] 
74 

PREPARED STATEMENT OF MARY L. SCHAPIRO 

CHAIRMAN, 

SECURITIES AND EXCHANGE COMMISSION

MARCH 26, 2009 

I. Introduction 

Chairman Dodd, Ranking Member Shelby, and Members of the Committee: Thank 

you very much for inviting me to testify as we face a critical juncture in the history 

of our Nation’s financial markets. I am here today testifying on behalf of the Commission as a whole. The Commission agrees that our goal is to improve the financial 

regulatory system, that we will work constructively to that end, and that we all are 

strongly dedicated to the mission of the SEC. In light of the economic events of the 

past year and their impact on the American people, I believe this Committee’s focus 

on investor protection and securities regulation as part of a reconsideration of the 

financial regulatory regime is timely and critically important. 

Thank you also for giving me an opportunity to talk about the historic mission 

of the Securities and Exchange Commission, what we do for the Nation’s investors 

and capital markets, and how our critical mission is a necessary foundation for a 

modernized financial regulatory structure. These are matters that have been the 

central focus of my entire professional career. 

I strongly support the view that there is a need for system-wide consideration of 

risks to the financial system and for the creation of mechanisms to reduce and avert 

systemic risks. I am convinced that regulatory reform must be accomplished without 

compromising the quality of our capital markets or the protection of investors. I am 

also convinced that getting it right will require hard work, attention to detail, and 

an over-riding commitment—not to engage in bureaucratic turf wars—but to further 

the public interest. All of that is well within our grasp. 

In my testimony this morning, I will explain some general principles that I believe should guide this effort. These principles are: first, an integrated capital markets regulator that focuses on investor protection is indispensable; second, that regulator must be independent; and third, a strong and investor-focused capital markets regulator complements the role of a systemic risk regulator, resulting in a more 

effective financial oversight regime. Included as an Appendix to my testimony is an 

overview of the major functions of the SEC, a summary of recent activity, and the 

resources allocated to each function. 

II. A Capital Markets Regulator Devoted to Investor Protection Is Indispensable 

All economic activity starts with capital. Small businesses need money to start up, 

and all companies need capital to innovate, compete, create jobs, and thrive. This 

capital comes from a variety of sources. Ultimately, capital comes from investors— 

people who invest directly in companies; people who invest in financial institutions 

that lend capital; people who invest in mutual funds and other pooled vehicles that 

in turn invest in America’s businesses; people who buy municipal securities to help 

fund the operations of state and local governments; and people who look to the capital markets to save, put away money for their kids’ education, and prepare for retirement. Markets that attract this capital are critical to America’s economic future. 

And a strong, focused, vibrant, and nimble market regulator is critical to getting 

investors back into the market and to maintaining their trust and confidence in the 

future. Such a regulator is fundamental to the future growth of our economy. 

That’s where the SEC comes in. Let me review some of the core functions of the 

SEC. These functions are interdependent: remove one function and the agency’s capacity to do the others is diminished. 

A. Regulation of the Integrity of Markets 

Investor protection starts with fair and efficient capital markets. In these tumultuous economic times, despite record volumes and enormous volatility, the markets 

that the SEC oversees have priced, processed, and cleared trillions of dollars in customer orders in an orderly and fair way. The dollar value of average daily trading 

volume was approximately $251 billion a day in February 2009 in stocks, exchangetraded options and security futures. By comparison, the average daily trading volume for such securities was approximately $87 billion a day in February 1999, and 

$10 billion a day in February 1989. 

The securities laws and our rules, and the rules of the exchanges and the national 

securities association we supervise, prohibit fraudulent trading practices, manipulation of securities prices, insider trading and other abuses. These laws and rules require trades to be executed at fair prices, require market participants to keep 
75 

records of their activities, and require prompt dissemination of pricing information. 

We regulate transfer agents and clearing agencies, so that transactions are effected 

seamlessly and without interruption. In overseeing the markets, the Commission is 

guided by its professional staff, which has extensive knowledge and expertise developed over decades of overseeing our Nation’s dynamic capital markets. 

Innovation has completely transformed our securities markets over the last decade. The shouts on the trading floors of the Nation’s securities exchanges have 

largely given way to the whir of computers. Transactions that took minutes to execute now take well under a second. In an instant, traders can search within markets 

and across markets to locate counterparties willing to pay the very best price. 

Spreads—that is the price differences in transactions captured by intermediaries 

rather than investors—have narrowed dramatically over the past decade. This has 

been due in part to the SEC’s rules requiring intermediaries acting for customers 

to trade at the very best prices as well as rules permitting securities prices to be 

quoted in pennies. In many instances, spreads in stocks have shrunk from 12 cents 

to less than a penny. According to a 2005 GAO study, decimalization of stock quotes 

alone cut trading costs by 30–50 percent. We’ve achieved similar results in the options markets. 

These pro-investor changes have been possible because of a regulatory regime that 

focuses on competition—one that does not pick winners and losers but instead, one 

that removes barriers to new entrants. It is a regime that requires a focus on the 

needs of investors and their welfare, allowing market participants to innovate and 

compete for their customers’ business. While it is a regime that works well, it is 

one that requires a regulator to keep up with the breakneck pace of change in our 

ever-evolving markets. 

This is not to say that our markets always function perfectly. There are practices 

that are contrary to fair and orderly markets; abusive short selling, for example, 

would fall into that category. To target potentially abusive ‘‘naked’’ short selling in 

certain equity securities, the Commission has tightened up the close-out requirements and adopted a new antifraud rule specifically aimed at abusive short selling 

when it is part of a scheme to manipulate the price of a stock. And, early next 

month, the Commission will consider proposals to re-institute the uptick rule, or 

something much like it. 

B. Regulation of the Integrity of Market Information 

However well structured, markets fail without timely and reliable information. 

Accurate information is the lifeblood of the securities market. A big part of the 

SEC’s mission is to safeguard the markets’ blood supply. We operate from the 

premise that our markets work best when investors are fully informed. Our job is 

to make sure investors get full and complete information. It involves setting meaningful disclosure standards, monitoring compliance with them, and, when appropriate, enforcing the law against those who fail to comply. It also involves programs 

to equip investors with tools to understand and analyze the market information 

they receive. 

SEC rules require complete and accurate disclosure of information that investors 

need to make informed investment and voting decisions. Companies cannot raise 

capital from the public without first filing with us comprehensive disclosures about 

their business, their performance, and their prospects. One of our major accomplishments over the last few years has been to streamline this process so that potential 

issuers of securities can raise money more quickly, while providing investors with 

more, and more current, information. 

Registrants file extensive disclosures about their business performance annually 

and update them quarterly, and—because today’s markets demand immediate information—whenever certain specified events occur. We review these filings on a selective basis, and work closely with reviewed companies to improve the quality of their 

disclosure. In fiscal year 2008, our staff reviewed the filings of nearly 5,000 reporting companies in addition to more than 600 new issuers. 

Accurate information, of course, encompasses both words and numbers, and we 

work to protect the integrity of both. We play a special role in the formation of accounting standards for public companies and other entities that file financial statements with the Commission. We oversee the process by which they are set to ensure 

that professional, independent standard-setters include those whose primary concern is the welfare of investors, that the deck is not stacked against investors, and 

that the outputs of the process are fair and appropriate. 

There is a delicate balance here. We have authority to set standards, and we use 

this authority prudently. Sometimes we prod the standard-setters to act more quickly, and we often give them the benefit of our views. But we are convinced that ac-
76 

counting standard-setting should be the product of an independent, expert body that 

is organized to act in the public interest and with appropriate due process. 

While the Commission rarely sets accounting standards, we deal with accounting 

matters every day. We and our staff provide guidance about how accounting standards should be applied in particular situations; our staff reviews corporate filings 

to determine whether companies are applying standards properly; and where the accounting is wrong, we ask companies to fix it. Our rules, given new vigor by the 

landmark Sarbanes-Oxley Act that emerged from this Committee in 2002, promote 

the independence of those who audit the financial statements of public companies. 

Investors need accurate and comprehensive information not only when they trade 

but also when they vote, whether it is to elect directors, adopt compensation plans, 

approve transactions, or consider shareholder proposals. And so we have a variety 

of means to promote fair corporate voting. 

Speaking for myself, I believe the SEC has not gone far enough in this latter area. 

And so I intend to make proxy access—meaningful opportunities for a company’s 

owners to nominate its directors—a critical part of the Commission’s agenda in the 

coming months. 

C. Regulation and Oversight of Financial Intermediaries and Market Professionals 

For our markets to be fair and efficient and to operate in the best interests of 

investors, those who control access to our capital markets must be competent, financially capable, and honest. That brings me to a third core function of the SEC: regulation and oversight of financial intermediaries and other market professionals, including approximately 5,500 broker-dealers, over 11,000 investment advisers, stock 

and option exchanges, clearing agencies, credit rating agencies and others. Exchanges and clearing agencies are an essential part of the plumbing of our financial 

system. Their smooth operation is something that many Americans take for granted, 

but that the Commission takes very seriously and works to ensure. Brokers, advisers and credit rating agencies are the entities that Americans turn to for guidance 

and technical assistance when accessing our Nation’s financial markets. It is essential that these firms—and the people who work in them—be held to the high standards expected of professionals. 

The SEC’s regulatory role, along with its oversight of the various self-regulatory 

organizations with respect to financial intermediaries and market professionals, focuses on helping to ensure that investors are treated fairly and that the institutions 

managing and processing their investments are subject to meaningful controls to 

protect investor assets. Our statutes and rules require that brokers and advisers tell 

investors the truth, that brokers recommend to their customers only those products 

that are suitable for them to buy, and that advisers act in accordance with their 

fiduciary duties. In the same way, we require that investment advisers manage any 

potential conflicts of interests and fully disclose them to investors. 

Our capital requirements go a long way to ensuring that customer funds entrusted with a broker-dealer are safe in the event the broker-dealer gets in financial 

trouble. Again, our focus is not to insulate broker-dealers from competition and the 

risks of failure, but to protect investors in the event that failures do occur. We conduct examinations of these firms to assess their compliance with laws and regulations. And when we find violations or deficiencies, we direct that corrective action 

be taken. 

Since 2006, with the authority provided by the Congress, we have adopted significant reforms related to credit rating agencies. Given the critical role of ratings in 

our capital markets, it is essential that we stay active in this area. We have rule 

proposals outstanding and are convening a public roundtable on possible further reforms to be held next month. 

Some of our rules regulating financial intermediaries need to be modernized, and 

the Commission is considering what, if any, legislation to ask for from the Committee. Among other things, we are considering asking for legislation that would require registration of investment advisers who advise hedge funds, and possibly the 

hedge funds themselves. We are studying whether to recommend legislation to 

break down the statutory barriers that require a different regulatory regime for investment advisers and broker-dealers, even though the services they provide often 

are virtually identical from the investor’s perspective. We also are carefully considering whether legislation is needed to fill other gaps in regulatory oversight, including those related to credit default swaps and municipal securities. It is time for 

those who buy the municipal securities that are critical to state and local funding 

initiatives to have access to the same quality and quantity of information as those 

who buy corporate securities. I will lead the Commission to continue to focus efforts 

in this area in 2009. 
77 

In addition, I have asked the staff to develop a series of reforms designed to better 

protect investors when they place their money with a broker-dealer or an investment adviser. I have asked the staff to prepare a proposal for Commission consideration that would require investment advisers with custody of client assets to undergo an annual third-party audit, on an unannounced basis, to confirm the safekeeping of those assets. I also expect the staff to recommend proposing a rule that 

would require certain advisers to have third-party compliance audits to review their 

compliance with the law. And to ensure that all broker-dealers and investment advisers with custody of investor funds carefully review controls for the safekeeping 

of those assets, I expect the staff to recommend that the Commission consider requiring a senior officer from each firm to attest to the sufficiency of the controls they 

have in place to protect client assets. The list of certifying firms would be publicly 

available on the SEC’s Web site so that investors can check on their own financial 

intermediary. In addition, the name of any auditor of the firm would be listed, 

which would provide both investors and regulators with information to then evaluate the auditors. 

D. Regulation of Mutual Funds and Other Pools of Investor Money 

Most retail investors participate in the capital markets through pooled investment 

vehicles, the most common of which are mutual funds. The size of these investments 

is astonishing: mutual funds hold over $9 trillion in assets—representing the investments of approximately 92 million Americans. As part of its oversight functions, the 

SEC focuses on ensuring that funds are run to benefit investors and not insiders. 

SEC rules also seek to ensure that fund investors are provided accurate, timely and 

complete information about their funds in a form that is investor-friendly. The SEC 

requires that funds comply with investor-oriented prohibitions against complex capital structures, excessive leverage and preferential treatment for certain shareholders. In addition, the SEC examines the actions of independent fund directors 

and chief compliance officers to evaluate whether they are fulfilling their critical responsibilities on behalf of fund investors. 

A particular focus of the Commission in coming weeks will be proposals to enhance the standards applicable to money market mutual funds, which are widely 

used by both retail and institutional investors as a cash management vehicle. The 

SEC has been closely monitoring money market funds and their investments, since 

we permitted the first money market fund in the early 1970s. Over that time, we 

have built up significant money market fund expertise. We will bring that expertise 

to bear as we act quickly this spring to strengthen the regulation of money market 

funds by considering ways to improve the credit quality, maturity, and liquidity 

standards applicable to these funds. These efforts will be aimed at shoring up 

money market fund investments and mitigating the risk of a fund experiencing a 

decline in its normally constant $1.00 net asset value, a situation known colloquially 

as ‘‘breaking the buck.’’ 

E. Enforcement of the Securities Laws 

Finally, there’s enforcement. We are an integrated regulator of the country’s capital markets with an important focus on law enforcement. We enforce the securities 

laws aggressively and intelligently, without fear or favor. Enforcement is one of our 

core competencies and a central part of our heritage as an agency. 

In the past year alone, the SEC has brought enforcement actions related to subprime abuses, market manipulation through the circulation of false rumors, insider 

trading by hedge funds and other institutional investors, Ponzi schemes, false corporate disclosures, and penny stock frauds. This past year we brought the biggest 

foreign bribery case ever. We also required securities violators to disgorge illegal 

profits of approximately $774 million and to pay penalties of approximately $256 

million, and we distributed over $1 billion to injured investors. 

Enforcement is integrated with our regulation of the capital markets for the benefit of investors. We enforce the securities laws and the rules we promulgate. We 

understand markets because we regulate them. We understand disclosure because 

we regulate it. Our regulatory functions add nuance and sophistication to our enforcement efforts, and enforcement adds backbone to our rules. It is all one piece. 

We have work to do to stay one step ahead of the predators and sharp practices 

that prey on investors. It is a never-ending struggle, and it requires never-ending 

energy and ingenuity. As part of this effort, I expect to come to you in the near term 

with a request for authority to compensate whistleblowers who bring us well-documented evidence of fraudulent activity. Currently, we have the authority to compensate sources in insider trading cases. I would like to see this authority extended 

so that the SEC can further encourage individuals to come forward with helpful information. 
78 

III. A Capital Markets Regulator Devoted to Investor Protection Should Be 

Independent 

As we look to the future of securities regulation, we believe that independence is 

an essential attribute of a capital markets regulator that protects investors. There 

are other agencies of government that touch on what we do, just as what we do 

touches on other agencies of government. But Congress created only one agency 

with the mandate to be the investors’ advocate. Other agencies have had, as part 

of their responsibilities, the protection of important financial institutions and, as 

part of those responsibilities, customer protection. But, as Justice Douglas pointed 

out long ago, only the SEC has the mission, and the privilege, of serving as ‘‘the 

investors’ advocate.’’ 

We are a creature of the Congress. The vision of the Congress when it created 

an independent SEC was to make sure that there was one agency of government 

focused single-mindedly and without dilution on the well-being of America’s investors. That independence has allowed us to build expertise and a culture of investor 

protection, which benefits the public and the economy. And it has been a tremendous success as U.S. capital markets lead the world. 

If there were ever a time when investors need and deserve a strong voice and a 

forceful advocate in the federal government, that time is now. Individual investors 

may not be the strongest political force; they are disparate in their backgrounds and 

not always well-organized or funded. They are typical Americans—our families, 

friends, and fellow citizens. These investors expect and deserve a strong and independent regulator dedicated to providing for fair financial dealings, timely and 

meaningful disclosure of information, and protection from unscrupulous actors. 

Congress made us independent precisely so we can champion those who otherwise 

would not have a champion, and when necessary take on the most powerful interests in the land. Regulatory reform must guarantee that independence in the future. 

IV. A Strong and Independent Capital Markets Regulator Is Important to 

Systemic Risk Oversight 

An independent, investor-first capital markets regulator is vital to a revamped 

regulatory structure that pays due attention to overarching systemic risk. Investor 

protection enhances the mission of controlling systemic risk. More than that, financial services exist to serve investors and our markets, and a focus on investors is 

absolutely essential to any credible regulatory restructuring. The SEC, as the independent capital markets regulator with unique experience and competencies, must 

continue to be the primary regulator of important market functions, and would be 

a critical party in contributing to any systemic risk regulator’s evaluation of risks. 

Appropriate regulation must safeguard both investor protections and important 

market functions. 

The SEC, as a strong independent regulator with market expertise, can perform 

its critical capital markets and investor protection functions without compromising 

the oversight of systemic risk. Even as attention focuses on reconsidering the management of systemic risk, investor protection and capital formation—both of which 

are fundamental to economic growth—cannot be compromised as a product of any 

reform effort. The SEC stands alone as the government agency responsible for both 

protecting investors and promoting capital formation for the past 75 years. 

To the extent the activities of the SEC touch systemically significant institutions, 

there is rarely a risk of inconsistency between the SEC and other regulators focused 

on systemic risk. No one, for example, argues that major financial institutions 

should be permitted to lie, cheat, or steal as a means of avoiding systemic risk. To 

the extent those issues do arise, and have arisen in the past, any tensions have been 

creative, and well-meaning regulators can and have been able to resolve them. 

There are questions that need to be answered in the months ahead. Among others, there is a need to identify or create the appropriate systemic regulatory regime; 

determine how such a regime can identify systemic risks without creating additional 

ones; and determine how much and how heavily any systemic risk regulator should 

touch the other participants in the system of financial regulation. We will need to 

figure out what should be consolidated, what should be split off, what should be 

added, and what should be subtracted. As it has since it was formed, the Commission stands ready to assist. 

We view regulatory reform as vital. We will give Congress, our fellow regulators, 

and other parts of the government the benefit of our insights. It is critical that the 

reform is done right, and the Commission will actively engage with all stakeholders 

throughout the process. 
79 

V. Conclusion 

When I returned to the SEC as Chairman in January, I appreciated the need to 

act swiftly to help restore investor confidence in our capital markets. In less than 

2 months, we have instituted important reforms to reinvigorate our enforcement 

program, better train our examination staff and improve our handling of tips and 

complaints. In the near term, I will ask the Commission to consider taking action 

related to short selling, money market fund standards, investor access to public 

company proxies, credit rating agencies, and controls over the safekeeping of investor assets. But, speaking personally, much more needs to be done. Everyday when 

I go to work, I am committed to putting the SEC on track to serve as a forceful 

capital markets regulator for the benefit of America’s investors. Today, more than 

ever, the SEC’s core mission of capital markets oversight and investor protection is 

as sound and fundamentally important as it ever was, and I am fully committed 

to ensuring that the SEC carries out that job in the most effective way it can. 

Thank you again for the opportunity to share the SEC’s views. We look forward 

to working with the Committee on any financial reform efforts in the months ahead, 

and I would be pleased to answer any questions. 
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84 

1The oldest international organization devoted to investor protection, the North American Securities Administrators Association, Inc., was organized in 1919. Its membership consists of the 

securities administrators in the 50 States, the District of Columbia, the U.S. Virgin Islands, 

Canada, Mexico, and Puerto Rico. NASAA is the voice of securities agencies responsible for 

grass-roots investor protection and efficient capital formation. 

PREPARED STATEMENT OF FRED J. JOSEPH 

PRESIDENT, 

NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION

MARCH 26, 2009 

Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I am 

Fred Joseph, Colorado Securities Commissioner and President of the North American Securities Administrators Association, Inc. (NASAA). 1 I am honored to be here 

today to discuss legislative and regulatory changes that are most relevant to the 

millions of Main Street Americans who are looking to regulators and lawmakers to 

help them rebuild and safeguard their financial security. At this critical time in the 

Nation’s history, it’s imperative that our system of financial services regulation be 

improved to better protect investors, markets, and the economy as a whole. I commend the Banking Committee for its deliberative approach of holding comprehensive hearings, briefings and meetings to determine how best to modernize our financial regulatory system. 

In November 2008, NASAA released its Core Principles for Regulatory Reform in 

Financial Services and subsequently issued a pro-investor legislative agenda for the 

111th Congress that responds to universal calls for increased responsibility, accountability, and transparency, and offers a series of positive and proactive policy 

recommendations to better protect investors and restore confidence in our financial 

markets. Today, I would like to highlight the recommendations that we feel are 

most vital to sound regulatory reform and strong investor protection. 

State Securities Regulatory Overview 

The securities administrators in your states are responsible for enforcing state securities laws, the licensing of firms and investment professionals, registering certain 

securities offerings, examining broker-dealers and investment advisers, pursuing 

cases of suspected investment fraud, and providing investor education programs and 

materials to your constituents. Ten of my colleagues are appointed by state Secretaries of State, five fall under the jurisdiction of their states’ Attorneys General, 

some are independent commissions and others, like me are appointed by their Governors and Cabinet officials. We are often called the ‘‘local cops on the securities 

beat,’’ and I believe that is an accurate characterization. 

NASAA’s Core Principles for Regulatory Reform in Financial Services 

The unique experiences of state securities regulators on the front lines of investor 

protection provide the framework for NASAA’s Core Principles for Regulatory Reform, which I want to discuss today. We believe Main Street investors deserve a regulatory structure that is collaborative, efficient, comprehensive, and strong and we 

have developed specific recommendations to help achieve those objectives. 

We urge you to consider and implement the following five guiding principles, 

which we believe will create a strong and practical foundation for an enhanced regulatory framework that better serves investors and our markets as a whole. 

• Preserve the system of state/federal collaboration while streamlining where possible. 

• Close regulatory gaps by subjecting all financial products and markets to regulation. 

• Strengthen standards of conduct, and use ‘‘principles’’ to complement rules, not 

replace them. 

• Improve oversight through better risk assessment and interagency communication. 

• Toughen enforcement and shore up private remedies. 

Congressional Action That Will Advance the Core Principles 

Implementing NASAA’s Core Principles will require a broad range of actions, both 

legislative and regulatory, but at the heart is a call for decisive Congressional leadership. Here are our specific legislative recommendations, set forth in the context 

of our core principles. 
85 

Core Principle One: Preserve State/Federal Collaboration While Continuing 

To Streamline the Regulatory System Where Appropriate 

With so much at stake for investors and the United States’ economy, NASAA’s 

top legislative priority is to protect investors by preserving state securities regulatory and enforcement authority over those who offer investment advice and sell 

securities to their residents. In some areas, the states’ authority should be increased. 

Support a Strong State Regulatory Structure for Capital Markets 

State regulation is an essential component of our current regulatory structure and 

it must be preserved. In the area of securities regulation, the states bring experience, resources, and passion to the job of licensing professionals, conducting examinations, and bringing enforcement actions—both civil and criminal—against those 

who prey on our Nation’s citizens. The states also serve as a local resource that investors can turn to for help when they have been exploited. 

Our proximity to individual investors puts us in the best position, among all law 

enforcement officials, to deal aggressively with securities law violations. State securities regulators respond to investors who typically call them first with complaints, 

or request information about securities firms or financial professionals. They work 

on the front lines, investigating potentially fraudulent activity and alerting the public to problems. Because they are closest to the investing public, state securities regulators are often first to identify new investment scams and to bring enforcement 

actions to halt and remedy a wide variety of investment related violations. The $60 

billion returned to investors to help resolve the demise of the Auction Rate Securities (ARS) market is the most recent example of the states initiating a collaborative 

approach to a national problem. 

Attached to my testimony is a chart, ‘‘States: On the Frontlines of Investor Protection,’’ which illustrates many examples where the states initiated investigations, uncovered illegal securities activity, then worked with federal regulators or with Congress to achieve a national solution. 

These high profile national cases receive greater public attention, but they should 

not obscure the more routine and numerically much larger caseload representing 

the bulk of the states’ enforcement work, which affects everyday citizens in local 

communities across the country. In the past three months alone, the Washington 

State Division of Securities, working with the Federal Bureau of Investigation and 

the IRS Criminal Investigation Division, broke up a $65 million oil and gas investment Ponzi scheme; Hawaii’s securities commissioner, with the assistance of the 

SEC and CFTC, shuttered a suspected Ponzi scheme targeting the deaf community 

in Hawaii, parts of the mainland and Japan; an investigation by the Texas State 

Securities Board resulted in a 60-year prison sentence for a Ponzi scheme operator 

who stole at least $2.6 million from investors; and the Arizona Corporation Commission stopped a religious affinity fraud ring and ordered more then $11 million returned to investors. Since January 1, 2009, the Alabama Securities Commission has 

announced the conviction of nine different individuals convicted of securities fraud. 

Just one look at our enforcement statistics shows the effectiveness of state securities regulation. During our three most recent reporting periods, ranging from 2004 

through 2007, state securities regulators have conducted investigations that led to 

more than 8,300 enforcement actions, which led to $178 million in monetary fines 

and penalties, more than $1.8 billion ordered returned to investors, and jail sentences totaling more than 2,700 years. 

Last year, in my own State of Colorado, my office conducted investigations that 

led to 246 administrative, civil and criminal actions, resulting in $3 million ordered 

to be returned to investors and 434 years of prison time for fraudsters. And just 

last month, a Ponzi scheme investigation launched by my office resulted in a prison 

sentence of 132 years for the main perpetrator and a court order to repay investors 

$3.4 million. 

In light of the demonstrable value of state securities regulation, we urge Congress 

to reject any attempts to preempt or otherwise restrict the role of state securities 

regulators. 

Restore the Authority of State Securities Regulators Over Offerings under Rule 506 

of Regulation D 

In thinking about the role of state and federal enforcement authorities, it is instructive to look back at the regulatory responses to the major financial scandals 

over the past decade. From the investigation into the role of investment banks in 

the Enron fraud, to exposing securities analyst conflicts of interest, ‘‘market timing’’ 

in mutual funds, and the recent auction rate securities cases, state securities regulators have consistently been in the lead. 
86 

2 Eric Zitzewitz, An Eliot Effect? Prosecutorial Discretion in Mutual Fund Settlement Negotiations, 2003–7, http://papers.ssrn.com/sol3/papers.cfm?abstractlid=1091035. 3See, e.g., Temple v. Gorman, 201 F. Supp. 2d 1238 (S.D. FL. 2002). 

Because we are the local cop on the beat, state securities regulators are often first 

to discover and investigate our Nation’s largest frauds. Also, it has been shown that 

in cases where state and federal regulators work cooperatively, the actions of state 

securities regulators cause a significant increase in the penalty and restitution components of the federal regulator’s enforcement efforts. 2

And yet, over a number of years there has been a concerted assault on state securities regulation, targeting both regulatory and enforcement activities. For example, 

in 1996, the National Securities Markets Improvement Act (NSMIA) preempted 

much of the states’ regulatory apparatus for securities traded in national markets, 

and although it left state antifraud enforcement largely intact, it limited the states’ 

ability to address fraud in its earliest stages before massive losses have been inflicted on investors. 

A prime example is in the area of private offerings under Rule 506 of Regulation 

D. Even though these securities do not share the essential characteristics of the 

other national securities offerings addressed in NSMIA, Congress nevertheless precluded the states from subjecting them to regulatory review. These offerings also 

enjoy an exemption from registration under federal securities law, so they receive 

virtually no regulatory scrutiny. Thus, for example, NSMIA has preempted the 

states from prohibiting Regulation D offerings even where the promoters or brokerdealers have a criminal or disciplinary history. Some courts have even held that offerings made under the guise of Rule 506 are immune from scrutiny under state 

law, regardless of whether they actually comply with the requirements of the rule. 3

As a result, since the passage of NSMIA, we have observed a steady and significant rise in the number of offerings made pursuant to Rule 506 that are later discovered to be fraudulent. Further, most hedge funds are offered pursuant to Rule 

506, so state securities regulators are prevented from examining the offering documents of these investments, which represent a huge dollar volume. Although Congress preserved the states’ authority to take enforcement actions for fraud in the 

offer and sale of all ‘‘covered’’ securities, including Rule 506 offerings, this power is 

no substitute for a state’s ability to scrutinize offerings for signs of potential abuse 

and to ensure that disclosure is adequate before harm is done to investors. In light 

of the growing popularity of Rule 506 offerings and the expansive reading of the exemption given by certain courts, NASAA believes the time has come for Congress 

to reinstate state regulatory oversight of all Rule 506 offerings by repealing Subsection 18(b)4(D) of the Securities Act of 1933. 

Broaden the States’ Regulatory and Enforcement Authority Over Investment Advisers 

Recent scandals have highlighted the need for more examination and enforcement 

in the area of investment adviser regulation. The Madoff case illustrates the horrific 

consequences we face when an investment adviser’s illegal activity goes undetected 

and unchecked for an extended period. NASAA recommends two changes to enhance 

the states’ role in policing investment advisers. First, the Securities Exchange Commission (SEC) should expand the class of investment advisers that are subject to 

state registration and oversight. In NSMIA, adopted in 1996, Congress provided 

that the states would regulate investment advisers with up to $25 million in assets 

under management, while the SEC would regulate the larger investment advisers. 

Congress further intended that the SEC would periodically review this allocation of 

authority and adjust it appropriately. The $25 million ‘‘assets under management’’ 

test should now be increased to $100 million. This adjustment is appropriate in light 

of changes in the economic context. Today, even small investment advisers typically 

have more that $25 million under management. In addition, this increase will reduce the number of federally registered investment advisers, thereby permitting the 

SEC to better focus its examination and enforcement resources on the largest advisers. 

Congress should also increase the states’ enforcement authority over large investment advisers. Currently, a state can only take enforcement action against a federally registered investment adviser if it finds evidence of fraud. This authority should 

be broadened to encompass any violations under state law, including, dishonest and 

unethical practices. This enhancement will deter all forms of abuse by the large investment advisers, without interfering with the SEC’s exclusive authority to register 

and oversee the activities of the large investment advisers. 
87 

4See Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). 

Core Principle Two: Close Regulatory Gaps by Subjecting All Financial 

Products and Markets to Regulation 

An enormous amount of capital is traded through esoteric investment instruments 

on opaque financial markets that are essentially unregulated. Our system must be 

more comprehensive and transparent, so that all financial markets, instruments, 

and participants—from derivatives to hedge funds—are subject to effective regulation through licensing, oversight, and enforcement. 

Increase Transparency of Derivative Instruments 

The lack of regulation governing the over-the-counter derivatives market is a regulatory gap that Congress must close. The hands-off approach to these financial instruments can be traced largely to the Commodity Futures Modernization Act, 

passed by Congress in 2000, which specifically exempted swaps from regulatory 

oversight. This lack of oversight was a contributing cause of the financial crisis and 

must be addressed. 

NASAA believes that Congress, at a minimum, should pass legislation to subject 

derivatives to much more comprehensive regulation. NASAA supports recent efforts 

to provide clearing services for certain credit default swap contracts, but suggests 

that Congress explore the necessity of imposing a much broader range of regulatory 

safeguards over the derivative markets. Regulatory requirements that deserve careful consideration include mandatory exchange trading, licensing of market participants, capital requirements, recordkeeping obligations, conduct standards, enforcement remedies, and even prohibition, where appropriate. 

Authorize Regulation of Hedge Funds 

NASAA has long supported regulation of hedge fund advisers in a manner that 

will provide greater transparency to the marketplace while not overburdening the 

hedge fund industry. Advisers to hedge funds should be subject to the same standards of examination as other investment advisers. 

Because they qualify for a number of exemptions to federal and state registration 

and disclosure laws, hedge funds remain largely unregulated today. The SEC has 

attempted to require hedge fund managers to register as investment advisers, but 

that attempt has been rejected. 4 Therefore, Congress should give the SEC explicit 

statutory authority to regulate hedge fund advisers as investment advisers. In addition, Congress should grant the SEC authority to require hedge funds to disclose 

their portfolios, including positions, leverage amounts, and identities of counterparties to the appropriate regulators. 

Core Principle Three: Strengthen Standards of Conduct, and Use ‘‘Principles’’ To Complement Rules, Not Replace Them 

At the heart of any regulatory system are strong and clear standards of conduct. 

In the area of securities regulation, we should impose the fiduciary duty—in addition to existing standards—on all securities professionals who dispense investment 

advice, including broker-dealers. We must also recognize that a ‘‘principles-based’’ 

approach to regulation is no substitute for a clear and strong system of prescriptive 

rules. Broadly framed standards of conduct can serve as helpful guides for industry 

as well as useful enforcement tools for regulators, but standing alone, they leave too 

much room for abuse. 

Impose the Fiduciary Duty on Broker-Dealers as Well as Investment Advisers 

Over the last two decades, broker-dealers have increasingly engaged in services 

traditionally rendered by investment advisers. The conduct of investment advisers, 

broker-dealer agents and financial planners has become increasingly blurred in recent years, and most investors do not understand the legal obligations that each 

have to their clients. The financial services industry today continues to expose investors to vast differences in competency exam requirements, education requirements, product knowledge, regulatory structures, and investor protections—including vast differences in the standard of care owed to the client. 

The primary purpose of the Investment Advisers Act of 1940 was to protect the 

public and investors from unscrupulous practices by those who dispense investment 

advice about securities for compensation. Congress set out to accomplish this goal 

in large part by establishing a federal fiduciary standard to govern the conduct of 

investment advisers. The fiduciary duty is the obligation to place the client’s interests first, to eliminate any conflicts of interest and to make full and fair disclosure 

to clients. NASAA urges Congress to apply the fiduciary duty standard of care to 

all financial professionals who give investment advice regarding securities—broker- 
88 

dealers and investment advisers alike. This step will enhance investor protection, 

eliminate confusion, and even promote regulatory fairness by establishing conduct 

standards according to the nature of the services provided, not the licensing status 

of the provider. We urge Congress to ratify the highest standard of care. For all financial professionals, the interests of the client must come first at all times. Investors deserve no less. 

Core Principle Four: Improve Oversight Through Better Risk Assessment 

and Interagency Communication. 

Enhancing our ability to detect and manage risk in all financial markets is one 

of our most important—and difficult—challenges. The single most effective remedy 

for excessive risk accumulation is closing regulatory gaps, as set forth in Core Principle Two. If we ensure that every financial product is subjected to strong oversight 

by competent regulators, we will have taken a major step toward better risk assessment and control. Some additional steps are necessary, however. Congress should 

establish an independent risk assessment body, and it should eliminate fundamental conflicts of interest that have undermined the objectivity and reliability of 

our credit rating agencies. 

Establish an Independent Body To Monitor the Accumulation of Risk and Recommend Corrective Measures 

NASAA believes that Congress should establish an independent risk assessment 

body comprised of representatives from the state and federal agencies that regulate 

securities, banking, and insurance. Their task would be to monitor the accumulation 

of risk in all financial markets, to advise the regulators who have primary jurisdiction over those markets, and to recommend decisive corrective measures when necessary. They would also be charged with identifying the emergence of new financial 

products that require regulation. This approach is preferable to vesting broad risk 

assessment authority in an existing federal agency. A new body with diverse and 

balanced representation offers more expertise, more objectivity, and greater resistance against industry influence or ‘‘regulatory capture.’’ 

On a more informal level, to facilitate communication and coordination on all financial services issues, NASAA believes the President’s Working Group on Financial Markets should be expanded to include representatives from the state agencies 

that regulate banking, insurance, and securities. 

Eliminate Conflicts Within Nationally Recognized Statistical Rating Organizations 

(‘‘NRSROs’’) 

Nationally Recognized Statistical Rating Organizations (‘‘NRSROs’’), or credit rating agencies, play a vital role in our capital market. Their evaluations of the creditworthiness of companies and securities help hedge funds, mutual funds, pension 

funds, and individual investors make their investment decisions, and their ratings 

are used for a variety of regulatory purposes as well. As our financial markets have 

become more complex, the role of NRSROs has grown in significance. However, it 

is now clear that NRSROs contributed to the turmoil in our credit markets with inaccurate ratings due in large part to a faulty business model. NASAA regards the 

SEC’s recently finalized rules, which were intended to curb conflicts of interest and 

increase transparency and accountability, as a constructive first step, but they may 

not go far enough. Also, the SEC’s upcoming roundtable should yield additional proposals to enhance oversight of the ratings industry. Still, Congress must examine 

the models that rating agencies use and the assumptions they rely upon in determining ratings to ensure that they accurately reflect risks. Congress should also examine the issuer-pay business model that contains inherent conflicts of interest and 

that lends itself to ‘‘ratings shopping,’’ and should consider legislative solutions that 

are beyond the reach of the SEC’s regulatory authority. 

Core Principle Five: Toughen Enforcement and Shore Up Private Remedies 

Enforcement is one of the most effective tools for deterring lawless behavior in 

our markets, but for years, it has received far less support than it deserves. We 

should toughen punishments for those who violate the law and increase enforcement 

budgets for state and federal regulators, including the SEC. We must remember 

that the private rights and remedies of injured consumers are an essential complement to government enforcement efforts aimed at deterring fraud. The pendulum 

has swung too far in the direction of limiting private rights of action, and now Congress should legislatively reverse some of the Supreme Court’s most ill-conceived 

and anticonsumer decisions. 
89 

5See S. Rep. No. 104-98, at 8 (1995), reprinted in 1995 U.S.C.C.A.N. 679, 687; see also Basic 

Inc. v. Levinson, 485 U.S. at 230–31 (observing that the private cause of action for violations 

of Section 10(b) and Rule 10b-5 constitutes an ‘‘essential tool for enforcement of the 1934 Act’s 

requirements’’). 6Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761, 779 (2008). 

Reexamine and Remove Some of the Hurdles Facing Private Plaintiffs Who Seek 

Damages for Securities Fraud 

Private actions are the principal means of redress for victims of securities fraud, 

but they also play an indispensable role in deterring fraud and complementing the 

enforcement efforts of government regulators and prosecutors. Congress and the 

courts alike have recognized this fact. The Senate Report accompanying the Private 

Securities Litigation Reform Act of 1995 (PSLRA) described the importance of private rights of action as follows: 

The SEC enforcement program and the availability of private rights of action together provide a means for defrauded investors to recover damages 

and a powerful deterrent against violations of the securities laws. As noted 

by SEC Chairman Levitt, ‘‘private rights of action are not only fundamental 

to the success of our securities markets, they are an essential complement 

to the SEC’s own enforcement program.’’ [citation omitted] 5

The problem, of course, is that over the last 15 years, Congress and the U.S. Supreme Court have restricted the ability of private plaintiffs to seek redress in court 

for securities fraud. These restrictions have not only reduced the compensation 

available to those who have been the victims of securities fraud, they have also 

weakened a powerful deterrent against misconduct in our financial markets. 

For example, in the PSLRA, Congress imposed stringent pleading requirements 

and other limitations on plaintiffs seeking damages for fraud under the securities 

acts. The intent of the Act was to protect companies from frivolous lawsuits and 

costly settlements. Many observers, however, believe that PSLRA has placed unrealistic burdens on plaintiffs with meritorious claims for damages. 

The Supreme Court has compounded the problem by issuing decisions that further limit the rights of private plaintiffs in two important ways. The Court has narrowed the class of wrongdoers who can be held liable in court, and at the same time, 

it has expanded the pleading burdens that plaintiffs must satisfy to survive immediate dismissal of their claims. As Justice Stevens lamented in his dissent in 

Stoneridge, the Court has been on ‘‘a continuing campaign to render the private 

cause of action under Section 10(b) toothless.’’ 6

In short, the pendulum has swung too far in the direction of limiting private 

rights of action. Congress should therefore hold hearings to examine whether private plaintiffs with claims for securities fraud have fair access to the courts. In that 

process, Congress should re-evaluate the Private Securities Litigation Reform Act 

and should furthermore consider reversing some of the Supreme Court’s most antiinvestor decisions. One case that undoubtedly deserves to be revisited is the Court’s 

holding in Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 

114 S.Ct. 1439 (1994). The Court ruled that the private right of action under Section 

10(b) of the Securities Exchange Act of 1934 cannot be used to recover damages 

from those who aid and abet a securities fraud, only those who actually engage in 

fraudulent acts. The Court’s decision insulates a huge class of wrongdoers from civil 

liability for their often critical role in support of a securities fraud. 

Other cases that warrant legislative re-evaluation include Stoneridge Investment 

Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761, 779 (2008) (severely limiting the application of Section 10(b) in cases involving fraudulent conduct); and 

Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007) (establishing 

burdensome requirements for pleading scienter). 

It bears repeating that removing excessive restrictions on access to the courts 

would not only provide more fair and just compensation for investors, it would also 

benefit regulators by restoring a powerful deterrent against fraud and abuse: the 

threat of civil liability. 

Restore Fairness and Balance in the Securities Arbitration System 

Every year thousands of investors file complaints against their stockbrokers. Almost every broker-dealer presently includes in their customer agreements a 

predispute mandatory arbitration provision that forces those investors to submit all 

disputes that they may have with the firm and/or its associated persons to mandatory arbitration. 

If these disputes are not settled with a given firm, investors are left with only 

one avenue to pursue their claims—arbitration—and for all practical purposes only 
90 

one arbitration forum. This system, which is administered by an affiliate of FINRA, 

should be revised to ensure it is fair and transparent to all. 

The first step toward ensuring fundamental fairness is to make arbitration optional. Members of Congress have seen that the scales of justice have tilted away 

from consumers in arbitration proceedings. In an attempt to rectify this situation, 

the ‘‘Arbitration Fairness Act of 2007,’’ was introduced. S. 1782, offered last year 

by Senator Russ Feingold (D-WI), had seven cosponsors and its House counterpart, 

H.R. 3010, introduced by Congressman Hank Johnson (D-GA), is currently supported by 43 cosponsors. This proposal makes predispute mandatory arbitration 

agreements to arbitrate employment, consumer, franchise, or civil rights disputes 

unenforceable. NASAA supports this legislation and suggests that it be amended 

just to make clear that its provisions extend to securities arbitration. 

Even if the decision to participate in arbitration becomes truly voluntary, other 

changes are necessary to ensure that the arbitration process is fair. NASAA believes 

a major step toward improving the integrity of the arbitration system is the removal 

of the mandatory industry arbitrator. This mandatory industry arbitrator, with 

their industry ties, automatically puts the investor at an unfair disadvantage. State 

securities regulators believe Congress should also review other aspects of arbitration, to determine, for example, if there is sufficient disclosure of potential conflicts 

by panel members; if the selection, qualification, and composition of the panels is 

fair to the parties; if arbitrators receive adequate training; if explanations of awards 

are sufficient; and if the system is fast and economical for investors. Where deficiencies are found, Congress should act to ensure that the system is improved. 

Conclusion 

State securities regulators believe that enhancing our securities laws and regulations and ensuring they are being vigorously enforced is the key to the restoring 

investor confidence in our markets. NASAA and its members are committed to 

working with the Committee to ensure that the Nation’s financial services regulatory regime undergoes the important changes that are necessary to enhance Main 

Street investor protection, which state securities regulators have provided for nearly 

100 years. 
91 
92 

1The views expressed here today are solely my own. They do not represent the views of any 

investors in investment funds managed by Breeden Capital Management, or of any companies 

on whose boards I serve. 

PREPARED STATEMENT OF RICHARD C. BREEDEN 

FORMER CHAIRMAN, 

SECURITIES AND EXCHANGE COMMISSION

MARCH 26, 2009 

Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee for the opportunity to offer my views on enhancing investor protection and 

improving financial regulation. These have been issues of concern to me for many 

years. 

In offering observations to the Committee today, I am drawing on past experience 

as SEC Chairman from 1989–1993, as well as my service as an Assistant to the 

President in the White House under President George H.W. Bush. During the savings and loan and banking crisis in the 1980s, which involved more than $1 trillion 

in bank and thrift assets, I was one of the principal architects of the program to 

restructure the savings and loan industry and its regulatory system. That effort was 

extremely successful, and became the model for many other countries including the 

Nordic countries in dealing with later banking sector meltdowns. 

Early in my White House tenure, in 1982–1985 when the future President Bush 

was Vice President, I was staff director of a 3-year study of how to improve the effectiveness and efficiency of the entire federal financial regulatory system. We 

looked carefully at many ideas for improving the effectiveness of federal financial 

regulation, including possible consolidation of banking agencies, SEC/CFTC merger 

and other topics. 

From 2002–2005 I served as the ‘‘corporate monitor’’ of WorldCom, after being appointed to that position by the Hon. Jed S. Rakoff of the U.S. District Court for the 

Southern District of New York. Among other things, it was my job on behalf of the 

District Court to evaluate and approve or veto all compensation payments by 

WorldCom to any of its 66,000 employees in more than 50 countries. We didn’t call 

it an ‘‘AIG Problem’’, but Judge Rakoff was determined to prevent exactly the type 

of compensation abuses that have occurred in AIG. Even though taxpayer funds 

were not injected into WorldCom, Judge Rakoff did not believe that a company that 

had destroyed itself through fraud should be free to pay corporate funds to insiders 

without strict monitoring and controls. I ultimately blocked hundreds of millions in 

proposed compensation payments that could not be justified, while allowing the company to do what it needed to do to compete for critical personnel and to emerge successfully from bankruptcy. 

Over the years I have served on many corporate boards, including the boards of 

two major European corporations as well as U.S. companies. Today I serve as nonexecutive Chairman of the Board of H&R Block, Inc., and as a director of two other 

U.S. public companies. 1 As a board chairman and as a director, I have personally 

had to grapple with the issues of corporate governance, including accountability for 

performance and excessive compensation, that helped cause so many of our recent 

financial institution collapses. 

Of all my prior experiences, however, perhaps the most relevant is my experience 

as an investor. For the past few years my firm, Breeden Capital Management, has 

managed equity investments that today total approximately $1.5 billion in the U.S. 

and Europe. Our investors are for the most part major pension plans, and we indirectly invest on behalf of several million retired schoolteachers, firemen, policemen, 

civil servants and others. Their retirement security is dependent in part on how successful we are in generating investment returns. While I was pretty intense about 

investor protection as SEC Chairman, I can assure you that there is nothing like 

having billions on the line in investments on behalf of other people to make you 

really passionate on that subject. 

I. Overview 

By any conceivable yardstick, our Nation’s financial regulatory programs have not 

worked adequately to protect our economy, our investors, or our taxpayers. In little 

more than a year, U.S. equities have lost more than $7 trillion in value. Investors 

in financial firms that either failed, or needed a government rescue, have had at 

least $1.6 trillion in equity wiped out. These are colossal losses, without any precedent since the Great Depression. Millions of Americans will live with reduced retirement incomes and higher taxes for many years as a result of misbehavior in our 
93 

financial firms, failed oversight by boards of directors, and ineffective government 

regulation. 

To restore trust among investors in our financial system and government, we will 

need to make significant improvements in our existing regulatory programs. We also 

must make sure that ‘‘new’’ regulatory programs will actually be ‘‘better’’ than current programs. Any ‘‘reforms’’ worth the name must demand more effectiveness from 

government agencies, including the Federal Reserve and the SEC, that have responsibility for ‘‘prudential supervision’’ of banks and securities firms. 

It is worth noting that the disasters we have seen did not arise due to lack of 

resources for the Federal Reserve, the SEC or any of the other agencies that didn’t 

perform as well as they needed to do. The U.S. regulatory system is enormous and 

powerful, and it generally has adequate, if not perfect, resources. When it comes to 

regulation, bigger doesn’t mean smarter, better or more effective. Indeed, when 

agencies have too many resources they tend to become unwieldy, not more vigilant 

or effective. 

The problems also did not arise because of ‘‘outdated laws from the 1930s’’ or, except in limited circumstances, from ‘‘gaps’’ in statutory authority in the banking or 

securities sectors. The fact is that some of the laws enacted in the 1930s in the wake 

of the Depression, like the Glass-Steagall Act, helped prevent leverage or conflict 

problems. When they were repealed in order to allow the creation of Citigroup, and 

to permit other financial firms to expand across traditional legal barriers, we may 

have gone too far in ‘‘modernizing’’ our system without incorporating adequate alternative limits on conflicts and leverage. Other laws from the 1930s, such as the Securities Act of 1933 and the Securities Exchange Act of 1934, have been regularly updated over the years to maintain their relevance in modern markets. 

Many people are today pointing at ‘‘gaps’’ in the regulatory structure, including 

‘‘systemic risk authority’’. If the Fed hasn’t been worried about systemic risk all 

these years, then people really should be fired. The problems we have experienced 

grew in plain sight of all our regulators. For the most part, we lacked adequate 

leadership at major regulatory agencies, not legal jurisdiction. The banking and securities regulators generally had the tools to address the abusive practices, but just 

didn’t use their powers forcefully enough or ask for new authority promptly when 

they needed it. Oversight of derivatives and swap markets is probably the major exception where firms like AIG were operating far outside of anyone’s oversight authority. That is a good reason to refuse to bail out swap counterparties of AIG in 

my opinion, but we also ought to put formal oversight into place if we are going 

to force taxpayers to make good on defaulted swaps. 

Part of the problem was an excessive faith by some regulators in enlightened self 

interest by banks and securities firms, and an underestimation of the risks posed 

by compensation practices that encouraged unsustainable leverage. Short term profits went home with the CEOs, while long term risks stayed with the shareholders. 

There also was a too trusting acceptance of ‘‘modern’’ bank internal risk models, 

which were used to help rationalize dangerous levels of leverage. Some regulators 

acquiesced to stupid things like global banks running off balance sheet ‘‘SIVs’’ in 

order to try to boost profits and compensation, even if they involved serious potential liquidity risks. Unfortunately, the risk-adjusted Basle capital rules for banks 

proved too simplistic and ineffective. To be fair, the SEC at the highest levels could 

have cracked the whip harder on Bear, Lehman, and Merrill, but didn’t do so. 

Rather than simply calling for more authority for people who didn’t use the authority they already had, we need to reexamine why our regulators missed so many 

of the risks staring them in the face. My purpose is not to fault regulators who 

weren’t perfect. I also don’t want to obscure the fact that the greatest responsibility 

for the devastation of our economy should rightly fall on the executives of the firms 

engaging in wildly risky practices, and the boards that failed to provide effective 

oversight. However, we will never design sensible reforms if we aren’t candid in acknowledging the performance failures all across the system. We can’t fix things 

until we have a good handle on what went wrong. 

It isn’t enough for regulators to write rules and give speeches. More time needs 

to be spent conducting examinations, analyzing results, discovering problems and, 

where necessary putting effective limits in place to prevent excessively risky activities. Directors and regulators need backbone, and a willingness to shut down a 

party that gets out of control. Regulators can’t catch all the frauds any more than 

police can catch all the drug dealers. Nonetheless, when failures happen it shouldn’t 

be acceptable to just ask for more resources without making the necessary corrections first. Regulators need accountability for performance failures just as much as 

any of us. 

While we need to demand better effectiveness from regulators, we must not shift 

the burden of running regulated businesses in a sound and healthy manner from 
94 

management and the boards of directors that are supposed to oversee their performance. Excessive leverage, compensation without correlation to long term performance, misleading (or fraudulent) accounting and disclosure, wildly overstated asset 

values, failures to perform basic due diligence, wasteful capital expense and other 

factors contributed to the financial collapses that devastated investors and undermined confidence in the entire economy. These are all issues that boards are supposed to control, but over and over again boards at AIG, Fannie Mae, Lehman 

Brothers, Bank of America and other companies didn’t address them adequately. 

In my experience, excessive entrenchment leads many directors to believe they 

don’t need to listen to the shareholders they represent, and who have the most at 

stake if the board fails to do a good job. The national disaster of self-indulgence in 

compensation has been opposed by many shareholders, but too many boards feel 

free to disregard their concerns. It is frankly almost incomprehensible how few directors of firms requiring taxpayer assistance have been forced to step down, even 

after investors and taxpayers lost billions because directors didn’t act prudently. If 

you allow your CEO to spend $35 billion on an acquisition without meaningful due 

diligence, for example, you should be replaced as a director without delay. The failure of boards to provide informed and independent oversight badly needs to be addressed both by Congress and the SEC. 

Taxpayers may have to protect our banking system, but they don’t have to protect 

the bankers who caused their firms to fail or the directors who let them do it without proper oversight. Executives who gambled with the solvency of their firms and 

failed should be out of a job, and the same is true for the boards that didn’t act 

as required. That is certainly how we handled the failures of the savings and loans. 

People who gambled and failed found new lines of work. There are few things today 

that would go farther to produce prudent behavior in the future than forcing the 

resignation of CEOs and directors when their firms have to take public funds to 

keep their doors open. It is long overdue to put accountability and personal responsibility front and center back into the system. 

Since we are going to need vast amounts of future savings and investment, the 

Committee’s efforts to help develop answers to the many tough issues affecting our 

system could not be more important. I will try to address the issues raised by the 

Committee’s thoughtful letter of invitation, as well as several of my suggestions for 

reform. 

A. Investor Protection 

With $7 trillion in investor losses, it would appear that we have not done enough 

in the area of investor protection. This was ironically once one of the preeminent 

strengths of the U.S. market. Investors from around the world invested in the U.S. 

because we had stronger and better accounting rules, more timely and detailed disclosure, a commitment to openness in corporate governance and above all enforcement of the rules and liability for those that committed illegal practices. Over time 

our governance standards have come to be weaker than those of many other countries, and our commitment to accuracy in accounting and disclosure has slipped considerably. The SEC’s enforcement program in recent years has not been as effective 

as the times demanded, with too many smaller cases and not enough focus on the 

largest problems. We frankly spent too much time worrying about the underwriting 

fees of Wall Street and not enough time worrying about protecting investors from 

false and misleading information. 

Investors, those quaint people worried about their retirement, need to stop seeing 

the savings they worked hard to accumulate wiped out because executives took irresponsible gambles. If we care about generating a higher national savings rate, we 

need to start paying more attention to the interests of individual and institutional 

investors and spend less time listening to the CEOs of the very banks who created 

this mess. We shouldn’t ever ignore opportunities to reduce unnecessary regulatory 

costs, but we can’t lose sight of the fact that people who lie, cheat and steal from 

investors belong in jail. We expect the cops on the beat to arrest street criminals, 

and we should equally expect the financial cops on the beat to use their muscle to 

protect the investing public. 

The record of the SEC in recent years has not been perfect. The Madoff case is 

a tragic situation that should have been caught sooner, for example. Chairman 

Schapiro has made a good start to reinvigorating the agency’s enforcement programs, and she deserves strong support in beefing up the agency’s programs. 

The SEC is a critical institution, and Congress should not throw away 75 years 

of SEC experience by stripping the agency of its responsibilities under the guise of 

creating a ‘‘systemic regulator’’ or for any other reason. Make no mistake, as great 

as it is (and the Fed really is a great institution), the Federal Reserve is not 

equipped to protect investors. Transferring SEC accounting, disclosure or enforce-
95 

ment programs to the Fed would be a recipe for utter disaster. A strong and effective SEC is good for investors, and good for the health of our economy. If the agency 

stops behaving like a tiger for investors we need to fix it, not abandon it. 

There are many things that go into ‘‘investor protection’’. To me, the most critical 

need is for timely and accurate disclosure of material information regarding the performance of public companies. That means issuers should provide robust disclosure 

of information, and scrupulously accurate financial statements. Overstating the 

value of assets is never in investor interests, and if the system doesn’t require accurate values to be disclosed investors will simply withdraw from the market due to 

lack of confidence. There must be serious consequences if you falsify asset values 

and thereby mislead investors no matter how big your company. 

Good disclosure includes marking liquid securities to market prices, whether or 

not a bank wishes to hide its mistakes. While care is needed in marking positions 

to models where there isn’t a liquid market, in general the people who try to blame 

mark to market for the problems of insolvent institutions are simply wrong. The 

problem is that people bought stuff without considering all the risks, including a 

collapse of demand or liquidity. That isn’t the problem of the yardstick for measurement, it is a problem of incompetent business decisions. If I bought a share of stock 

at $100 and it falls to $50, that dimunition of value is real, and I can’t just wish 

it away. We need accuracy in accounting, not fairy tales. 

‘‘Transparency’’ of results to investors is the touchstone of an efficient market, and 

a vital protection to make sure that investors can accurately evaluate a company 

and its condition if the information is there and they are willing to do the work. 

It should never be allowable to lie or mislead investors, and people who do it should 

expect to be sued no matter what might happen to them in other countries. In my 

opinion there can be no ‘‘opt-out’’ of accountability for fraud and deliberate 

misstatements of material information. This is a bedrock value of our system and 

has to be defended even if business lobby groups find accurate disclosure inconvenient. 

Choice is another core protection for investors. Government shouldn’t try to make 

investment choices for investors, or allocate capital as it might wish. Particularly 

when it comes to sophisticated pension funds and other institutional investors, they 

need the right to manage their portfolios as they believe will generate the best returns without artificial limitations. Historically some states have tried to impose 

‘‘merit’’ regulation in which bureaucrats made investment choices for even the most 

sophisticated investors. Investment choice is a vital right of investors, subject of 

course to basic suitability standards, even though we know that investors will sometimes lose. 

Healthy corporate governance practices are also vital to investors. This means accountability for performance, enforcement of fiduciary duties, maintaining checks 

and balances, creating sensible and proportionate incentives and many other things. 

One area of weakness today is excessive entrenchment of boards, and the consequent weakening of accountability for boards that fail to create value. Better corporate governance will over time lead to a stronger companies, and more sustainable earnings growth and wealth creation. 

B. Systemic Risk and Supervision of Market Participants 

There appears to be momentum in Washington for creating a ‘‘systemic risk’’ regulator, whether the Federal Reserve or some other agency. To me, this is a bad idea, 

and one that will weaken the overall supervisory system as well as damaging Congressional oversight. 

There is no single person, and no single agency, that can be omniscient about risk. 

Risk crops up in limitless forms, and in the most unexpected ways. Risk is as varied 

as life itself. To me, our system is stronger if every agency is responsible for watching for, and acting to control, systemic risk in its own area of expertise. It needs 

to be every regulator’s responsibility to control risks when they are small, before 

they get big enough to have ‘‘systemic’’ implications. 

Our current system involves multiple federal and state decisionmakers, and multiple points of view. Like democracy itself, the system is a bit messy and at times 

leads to unproductive debate or disagreement, particularly among the three different bank regulators. However, Congress and the public have the benefit of hearing the different points of view from the Fed, the Treasury, the FDIC or the SEC, 

for example. This allows informed debate, and produces better decisions than would 

be the case if those different points of view were concealed from view within a single 

agency expressing only one ‘‘official’’ opinion. 

The alternative in some countries is a single regulator. Japan’s Ministry of Finance, for example, traditionally brought banking, securities and insurance regulation under one roof. However, Japan still has had as many problems as other mar-
96 

kets. Making agencies bigger often makes them less flexible, and more prone to complacency and mistakes. This can create inefficiency. More importantly, it can create 

systemic risk because if the regulatory ‘‘czar’’ proves wrong, every part of the system 

will be vulnerable to damage. Some regulators prove more effective than others, so 

a system with only one pair of eyes watching for risk is weaker than a system in 

which lots of people are watching. What counts is that somebody rings an alarm 

when problems are small enough to fix, not who pushes the button. 

Of course risk often comes about not just by the activity itself, but how it is conducted. Ultimately any economic activity can be conducted in a manner that creates 

risk, and hence there can be ‘‘systemic’’ risk anywhere. It won’t work to try to assign 

planning for every potential risk in the economy to a single agency unless we want 

a centrally planned economy like the old Soviet Union. This is an area where interagency cooperation is the better solution, as it doesn’t create the enormous new 

risks of concentration of power and the dangers of a single agency being asleep or 

flat out wrong as would a ‘‘systemic risk’’ supervisor. 

Supervision of market participants is best left in the hands of agencies that have 

the most experience with the particular type of activity, just as doctors and dentists 

need to be overseen by people who understand the practice of medicine or dentistry. 

It is particularly hard for me to see a case that any single group of regulators did 

such a good job that they deserve becoming the Uber Regulator of the country. The 

bank regulators missed massive problems at Wachovia, WaMu, Citicorp and other 

institutions. Insurance regulators missed the problems at AIG. The SEC missed 

some of the problems at Bear, Lehman and Merrill. There have been enough mistakes to go around, and I don’t see evidence that putting all supervision under a 

monopoly agency will improve insight or judgment. Unfortunately, the reverse effect 

is more likely. 

C. Common Supervisory Rules 

During my time as SEC Chairman, I was pressured (mostly by foreign regulators) 

to agree to a new ‘‘global’’ capital rule that would have reduced the SEC’s limits 

on leverage for the major U.S. securities firms by as much as 90 percent. The proposed new ‘‘global’’ capital rule on market risks represented a good theoretical endeavor, but it was too simplistic and unreliable in practice. It would have allowed 

firms that were long railroad stocks and short airline stocks to carry zero capital 

against those positions, even though they were not a true hedge. 

The ‘‘netting’’ arrangements in the proposed global rule weren’t economically realistic, and as a result the rule itself was largely a rationalization for allowing firms 

to lever themselves to a much greater degree than the SEC allowed at that time. 

In addition, the rule didn’t distinguish at all between securities firms that were 

marking securities portfolios to market, and banks that were using cost accounting, 

which meant that the capital required would vary dramatically from firm to firm 

for identical portfolio positions. The SEC staff and I believed that this new standard 

would have undercut the stability and solvency of the major U.S. securities firms. 

We didn’t object to banking authorities adopting whatever standards they thought 

were appropriate, but we weren’t willing to be stampeded into adopting something 

that we didn’t believe would work. 

At the time, much of the force for pushing through a new rule came from the 

Basle banking committee, who wanted to be seen to be doing something relevant 

to market risk even if the proposed rule had problems. It was my rather contrarian 

view then, and remains so today, that adopting a ‘‘global’’ rule that is ineffective 

is worse than no global rule at all. This is because if all the world’s major markets 

adopt the same rule and it fails, then financial contagion can spread throughout the 

world, not just one country. 

Global harmonization of standards creates some economic benefits by making operations in multiple countries more convenient and less complicated for global 

banks. These benefits must however be weighed against the risks that a ‘‘one size 

fits all’’ global rule may not work well in many individual markets because of differences in volatility, market size, the nature of the investor base or other economically relevant factors. Countries where the local regulator goes beyond the ‘‘global’’ 

norms to impose tougher standards on local banks, as the Bank of Spain did with 

reserves for derivatives and certain types of loans in the past few years, are better 

protected than those that have only a ‘‘global’’ standard that was worked out in 

international horse trading. 

When we back tested this proposed new lower capital standard against historic 

trading data from the 1987 Crash, the SEC staff found that the theoretical asset 

correlations didn’t always work. As a result, firms that had followed the proposed 

rule would have failed (unlike the actual experience, where major firms did not fail 
97 

because the SEC capital standards gave enough buffer for losses to prevent failures) 

when the market came under unexpected and extreme stress. 

My colleagues and I simply said ‘‘No’’ and kept our capital standards high in that 

case because we didn’t believe the proposed new standard was ready for use. Here 

my fellow Commissioners and I believed in the KISS principle. It is a certainty that 

over time markets will encounter problems of liquidity or valuation that nobody anticipated. If you have enough capital and are conservatively financed, you will survive and won’t risk massive loss to your investors, clients or taxpayers. 

This experience illustrates to me the very real risks that will be created by a ‘‘systemic’’ regulator if we try to do that, as well as from further ‘‘globalization’’ of regulation that makes the job of writing rules targeted narrowly to control specific risks 

more cumbersome. Active coordination across agencies and borders is vital to make 

sure that information and perspectives on risk are effectively communicated. Colleges of regulators work, and add real value. 

However, going beyond that to impose uniformity, especially on something like 

‘‘systemic risk’’ that isn’t even defined, quite possibly will end up making regulation 

more costly, less flexible and potentially weaker rather than stronger. An agency 

will adopt rules that sound great, but just may not work for one of a million reasons. That is a particular danger if the ‘‘systemic’’ regulator is free to overrule other 

agencies with more specific knowledge. The first thing a czar of ‘‘systemic risk’’ is 

likely to do is to create new systemic risk because whatever that agency chooses to 

look at may take on immediate ‘‘too big to fail’’ perceptions, and the moral hazards 

that go with that status. My preference would be to have a unified or lead banking 

supervisory agency, and active dialogue and discussion among agencies rather than 

putting the entire economy in one agency’s straightjacket. 

There will inevitably also be risks to the independence of the Fed if it performs 

a systemic regulator’s role, because you cannot allow an agency to impose needless 

costs on the entire economy without political accountability. When they fail to do 

anything about the next subprime issue, inevitably the Fed’s stature will be tarnished. To me, we would lose a great deal from distracting the Fed’s focus from 

monetary policy and stability of prices to have them traipsing around the country 

trying to figure out what risks GE or IBM pose to the economy. 

D. Reorganization of Failed Firms 

As SEC Chairman, I handled the 1990 closure and bankruptcy filing of Drexel 

Burnham Lambert, then one of the largest U.S. securities firms. We were able to 

prevent any losses to Drexel customers without cost to the taxpayers in our closure 

of Drexel. We froze and then sold the firm’s regulated broker dealer, transferring 

customer funds and accounts to a new owner without loss. Having protected the regulated entity and its customers, we refused to provide assistance to the holding company parent that had a large ‘‘unregulated’’ portfolio of junk bonds financed by sophisticated investors (including several foreign central banks that were doing gold 

repos with Drexel’s holding company parent). 

Though there were those who wanted us to bail Drexel out, we forced the holding 

company into Chapter 11 instead, and let the courts sort out the claims. A similar 

approach would work today for AIG and its unregulated derivative products unit, 

which could be left to sort out its claims from swaps customers in bankruptcy without taxpayer financing. This approach of stopping the safety net at regulated subsidiaries can be very helpful in unwinding failed firms where there are both regulated and unregulated entities at less cost and less damage to market disciplines 

than excessively broad bailouts. 

E. Risk Management 

Risk management is an important responsibility of every firm, and every regulator. However, a dangerous by-product of belief that we can manage risk in a very 

sophisticated manner is a willingness to tolerate higher levels of risk. After all, as 

long as risk is being ‘‘managed’’ it ought to be ok to have more of it. Ultimately unanticipated problems arise that cause even highly sophisticated models to fail to 

predict real life accurately. 

Every risk management system, and every risk adjusted capital rule, needs a minimum standard that is simple and comprehensive. Tangible capital as a percentage 

of total assets is a more comprehensive, and more reliable, measure of capital than 

the highly engineered ‘‘Tier One’’ Basle capital standards. I believe Congress should 

seriously study mandating that U.S. banking regulators establish a minimum percentage of tangible capital to total assets even if international capital rules might 

allow a lower number. Creating a ‘‘solvency floor’’ would have prevented at least 

some of the failures we have experienced. 
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F. Credit Rating Problems 

The credit rating agencies failed in evaluating the risk of ‘‘structured products’’. 

In part this reflects inherent conflicts of interest in the ‘‘for profit’’ structure of the 

rating agencies and their reliance on fees from people seeking ratings in order to 

generate their own earnings growth. Unfortunately a ‘‘AAA’’ rating acts as an effective laughing gas that leads many investors to avoid necessary due diligence or 

healthy levels of skepticism. If the structured mortgage instruments that devastated 

the economies of the western world had been rated BBB, or even A-, a great many 

of the people (including boards and regulators) who got clobbered would have looked 

more carefully at the risks, and bought less. There is a serious issue of conflict of 

interest in getting paid to legitimize the risk in a highly complex ‘‘structured’’ product laced with derivatives. 

G. Levered Short Selling 

Short selling doesn’t have the same benefit to the public as normal long investing. 

While short selling creates liquidity and shouldn’t be prohibited, it doesn’t have to 

be favored by regulators either. In my opinion the SEC should never have eliminated the uptick rule, which inhibits to some degree the ability of short sellers to 

step on the market’s neck when it is down. Beyond that, I believe that regulators 

should seriously consider imposing margin requirements as high as 100 percent on 

short positions. Leveraging short positions simply creates extreme downward pressure on markets, and may seriously impair market stability. 

H. Credit Default Swaps 

The CDS market is large, but it lacks transparency. It may also involve unhealthy 

incentives to buy securities without adequate capital or study on the false presumption that you can always buy ‘‘protection’’ against default later. We don’t appear to 

have enough capital for our primary financial institutions such as banks, insurance 

companies and brokerage firms, and there surely isn’t enough capital available to 

‘‘insure’’ every risk in the markets. But if the risks aren’t really insured, then what 

are the swaps? 

Another thing that is troubling is the ability to use the CDS market for highly 

levered speculative bets that may create incentives to manipulate other markets. I 

can’t buy fire insurance on my neighbor’s house due to obvious concerns about not 

inciting arson. Yet hedge funds that didn’t own any Lehman debt were free to hold 

default swap positions which would prove highly profitable if Lehman failed, and 

also to engage in heavy short selling in Lehman shares. I am concerned about allowing that much temptation in an unregulated and very opaque market, especially if 

taxpayers are supposed to underwrite it (although I can’t comprehend that either). 

This is a market that certainly would benefit from greater oversight and transparency, particularly as to counterparty risk. It would be worthwhile for an interagency group to consider appropriate limits on issuance or reliance on credit default 

swaps by regulated firms within the ‘‘official’’ safety net. There are huge and very 

murky risks in this market, and it might be prudent to consider limiting the dependence of regulated firms on this opaque corner of the markets. 

I. Regulatory Reform 

Immediately prior to my service as SEC Chairman, I served as Assistant to the 

President in the White House under President George H.W. Bush where I helped 

lead the Administration’s highly successful 1989 program to deal with the ∂$1 Trillion savings and loan crisis. This program was embodied in legislation called 

FIRREA that was passed by Congress in the summer of 1989. As some of you will 

remember, the savings and loan crisis, like our current crisis, had grown for years 

without effective government intervention to defuse the mortgage bomb of that era. 

Among other things, we created the Resolution Trust Corporation to take hundreds 

of billions in toxic mortgage assets out of bankrupt institutions, repackage them into 

larger and more coherent blocks of assets, and sell them back into private ownership as quickly as possible. 

We designed our intervention in the banking system to operate swiftly, and to recycle bad assets as quickly as possible rather than trying to hold assets hoping they 

would ultimately go up in value. Generally, troubled assets go down, not up, in 

value while under government ownership. Believing that the ice cube is always 

melting, we designed our intervention for speed. We also didn’t believe that any 

zombie banks should be allowed to linger on government life support competing with 

healthier firms that had not bankrupted themselves. We didn’t give bailouts to anyone, but we did provide fast funerals. 

One thing President Bush (41) was adamant about was that the taxpayers should 

never have had to divert hundreds of billions of dollars in tax revenues to paying 
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for the mistakes and greed of bankers. I quite vividly remember his unambiguous 

instructions to me to design regulatory reforms to go along with the financial intervention so that ‘‘as much as humanly possible we make sure this doesn’t happen 

again.’’ As part of that mandate, we imposed strict capital and accounting standards 

on the S&Ls, merged the FSLIC into the FDIC and beefed up its funding, established important new criminal laws (and the funding to enforce them), and abolished the former regulatory body, the Federal Home Loan Bank Board, which had 

failed in its supervisory responsibilities. 

Hopefully the Treasury’s newly announced Public–Private Program for purchasing 

distressed bank assets will work as well as the RTC ultimately did. The principles 

of using private sector funding and workout expertise are similar, and this is an 

encouraging attempt to help unlock the current system. Hopefully we will also eventually look to marrying taxpayer TARP money with greater accountability and more 

effective oversight as we did then. 

II. Specific Reforms 

In response to the Committee’s request, set forth below are several specific 

changes in law that I believe would improve the current system of investor protection and regulation of securities markets. 

1. Merge the SEC, CFTC, and PCAOB into a single agency that oversees trading 

in securities, futures, commodities and hybrid instruments. That agency should also 

set disclosure standards for issuers and the related accounting and audit standards. 

Most importantly, this agency would be primarily focused on enforcing applicable 

legal standards as the SEC has historically done. These closely intertwined functions have nothing to do with bank regulation, but a great deal to do with each 

other. I do not suggest a merger out of any lack of respect for each of the three 

agencies. However, a merger would help eliminate overlap and duplication that 

wastes public resources, and also reduces effectiveness. If a similar consolidation occurred of the bank supervisory programs of the Fed, the Treasury and the FDIC, 

then we would have a strong agency regulating banks, and another strong agency 

regulating public companies, auditors, and trading markets. 

2. Allow the five (or ten) largest shareholders of any public company who have 

owned shares for more than 1 year to nominate up to three directors for inclusion 

on any public company’s proxy statement. Overly entrenched boards have widely 

failed to protect shareholder interests for the simple reason that they sometimes 

think more about their own tenure than the interests of the people they are supposed to be protecting. 

This provision would give ‘‘proxy access’’ to shareholder candidates without the 

cost and distraction of hostile proxy contests. At the same time, any such nomination would require support from a majority of shares held by the largest holders, 

thereby protecting against narrow special interest campaigns. This reform would 

make it easier for the largest shareowners to get boards to deal with excessive risks, 

poor performance, excessive compensation and other issues that impair shareholder 

interests. 

3. Reverse or suspend the SEC decision to abandon U.S. accounting standards and 

to adopt so-called ‘‘International Financial Reporting Standards’’ for publicly traded 

firms headquartered in the U.S. At a time of the greatest investor losses in history 

and enormous economic stress, forcing every company to undergo an expensive transition to a new set of accounting standards that are generally less transparent than 

existing U.S. standards is not in investor’s interests. This will avoid considerable 

unproductive effort at a time businesses need to minimize costs and focus on economic growth, not accounting changes. Investors need more transparency, not less, 

and the SEC should not abdicate its role of deciding on appropriate accounting and 

auditing standards for firms publicly traded in the U.S. 

4. Broaden the ability of shareowners to put nonbinding resolutions on any topic 

related to a company’s business on its annual proxy statement, including any proposal by shareholders relating to the manner of voting on directors, charter amendments and other issues. Legislation would clarify the confusing law relating to the 

ability of shareholders to hold a referendum on whether a company should adopt 

majority voting for directors, for example. Shareholders own the company, and in 

the internet age there is no reason to limit what shareholders can discuss, or how 

they may choose to conduct elections for directors. SEC resources should no longer 

be devoted to arbitrating whether shareholders should be allowed to vote on resolutions germane to a company’s business. 

5. Prohibit ‘‘golden parachute’’ payments to the CEO or other senior officers of any 

public company, in the same way that Sarbanes Oxley prohibits loans to such executives. Golden parachutes have proven to be extraordinarily abusive to shareholders, 

and boards have proven themselves unable to control excessive payouts. Eliminating 
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supercharged severance will not unduly prejudice any company’s ability to recruit 

since no company will be able to offer or make abusive awards to failed executives. 

This provision would NOT prohibit signing bonuses or annual bonuses, as it would 

solely apply to payouts to executives who are departing rather than continuing to 

work. The fact is that paying failed executives to walk out the door after damaging 

or destroying their company is wrong, and it is part of the culture of disregard of 

shareholder interests that needs to change. 

6. Split the roles of Chairman of the Board and CEO in any company that receives 

federal taxpayer funds, or that operates under federal financial regulation. The traditional model of a Chairman and CEO combined in one individual weakens checks 

and balances and increases risks to shareholders compared with firms that separate 

those positions. Splitting these roles and requiring a prior shareholder vote to reintegrate them would reduce risks and improve investor protection. 

7. Eliminate broker votes for directors unless any such vote is at the specific direction of a client. Brokers should not cast votes on an uninstructed basis to avoid 

unwarranted entrenchment of incumbents or tipping the outcome of elections under 

federal proxy rules. Indeed, it may be time to consider a broader Shareholder Voting 

Rights Act to address many barriers to effective shareholder exercise of the vote. 

8. Establish a special ‘‘systemic bankruptcy’’ court composed of federal District or 

Circuit Court judges with prior experience in large bankruptcy or receivership cases 

similar to the Foreign Intelligence Surveillance Court. This new Systemic Court 

would handle the largest and systemically important bankruptcies with enhanced 

powers for extraordinary speed and restructuring powers. Use of such a Systemic 

Court would help limit ad hoc decisions by administrative agencies including the 

Fed or Treasury in handling large financial institution failures and treatment of different types of classes of securities from company to company. 

Utilizing a court with enhanced and expedited reorganization powers would allow 

reorganization or conservatorship proceedings rather than nationalization, and 

would facilitate the ability to break up and reorganize the largest failed firms under 

highly expedited Court supervision. Fed and Treasury officials would be able to 

focus on liquidity assistance under the aegis of the Systemic Court, which would 

allow enhanced priorities for taxpayer funds and control of compensation and other 

nonessential expenses. The Systemic Court should be authorized to appoint a corporate monitor in any case pending before it to control compensation expense or 

other issues. 

9. Establish effective and meaningful limitations on leverage in purchases of securities and derivative instruments where any person or entity is borrowing from a 

federally supervised bank or securities firm, or where such firms are establishing 

positions for their own account. 

10. Establish a permanent insurance program or liquidity facility for money market funds. Given recent experience, the uninsured nature of MMFs is an uncomfortably large risk to market stability. 

11. Establish strict liability for any rating agency if it awards a AAA or comparable other top rating grade to a security of a nonsovereign issuer that defaults 

within 3 years of issuance. While I would not create private rights of action for any 

other rating decisions, rating agencies should appreciate that awarding a AAA overrides many investor’s normal diligence processes, such that liability is warranted if 

the agency proves to be wrong. The SEC should generally revoke commercial ratings 

as an element of its disclosure or other regulations. 

12. Eliminate the deductibility of mortgage interest and replace it with deductibility of mortgage principal payments with appropriate overall limits. This would 

create incentives for paying off family debt, not perpetuating the maximum possible 

level of mortgage debt. At the same time, such a provision would result in significant new liquidity for banks as borrowers repaid performing mortgage loans. Middle 

class families would see real wealth increase if deductibility allows the effective duration of home mortgage loans to be reduced from 30 years to 15 years, for example, 

saving an average family hundreds of thousands of dollars in interest. Federal assistance would help families reduce the level of their debt, thereby strengthening 

the economy and boosting savings. 

Thank you for your consideration of these views and ideas. 
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PREPARED STATEMENT OF ARTHUR LEVITT 

FORMER CHAIRMAN, 

SECURITIES AND EXCHANGE COMMISSION

MARCH 26, 2009 

Thank you, Chairman Dodd and Ranking Member Shelby, for the opportunity to 

appear before the Committee at this critical moment facing our markets, our economy, and our Nation. 

When I last appeared before this Committee, I focused my remarks on the main 

causes of the crisis we are in, and the significant role played by deregulation. Today, 

I would like to build upon that testimony and focus your attention on the prime victim of deregulation—investors. Because of failures at every level of our financial 

system, investors no longer feel that they receive correct information or enjoy meaningful protections. Their confidence in fair, open, and efficient markets has been 

badly damaged. And not surprisingly, our markets have suffered from this lack of 

investor confidence. 

Above all the issues you now face, whether it is public angerμoverμbonus payments or the excesses of companies receiving taxpayer assistance, there is none 

more important than investor confidence. The public may demand that you act over 

some momentary scandal, but you must not give in to bouts of populist activism. 

Your goal is to serve the public not by reacting to public anger, but by focusing on 

a system of regulation which treats all market actors the same under the law, without regard to their position or status. 

In coming months, you will adopt specific regulatory and policy solutions to the 

problems we face, yet none of that work will matter much unless we find a way to 

restore investor confidence. If at the end of the process you don’t place investor confidence at the heart of your efforts, no system of regulation and no amount of spending on regulatory agencies can be expected to succeed. 

Core Principles 

You are focusing now on the issue of systemic risk, and therefore whatever response you take must be systemic as well. Specifically, some have suggested that 

we should re-impose Glass-Steagall rules regarding the activities and regulation of 

banks. Those rules kept the Nation’s commercial banks away from the kinds of risky 

activities of investment banks. But by 1999, the law no longer had the same teeth— 

multiple workarounds had developed, and it no longer was practical to keep it in 

place. Perhaps we were too hasty in doing away with it, and should have held onto 

several key principles that made Glass-Steagall an effective bulwark against systemic risk in America’s banking sector. That does not mean we should pursue ‘‘turnback-the-clock’’ regulation reforms and re-impose Glass-Steagall. The world of finance has changed greatly since 1999 and we have to change with it. But we can 

borrow some important principles from Glass-Steagall, apply them to today’s environment, as we address the serious weaknesses of our current system of financial 

regulation. 

Those principles, in short, are: 

Regulation needs to match the market action. If an entity is engaged in trading 

securities, it should be regulated as a securities firm. If an entity takes deposits and 

holds loans to maturity, it should be regulated as a depository bank. Moreover, regulation and regulatory agencies must be suited to the markets they seek to oversee. 

Regulation is not one size fits all. 

Accounting standards serve a critical purpose by making information accessible 

and comprehensible in a consistent way. I understand that the mere mention of accounting can make the mind wander, but accounting is the foundation of our financial system. Under no circumstances should accounting standards be changed to suit 

the momentary needs of market participants. That principle supports mark-to-market accounting, which should not be suspended under any condition. 

The proper role of a securities regulator is to be the guardian of capital markets. 

There is an inherent tension at times between securities regulators and banking supervisors. That tension is to be expected and even desired. But under no circumstance should the securities regulator be subsumed—if your goal is to restore 

investor confidence, you must embolden those who protect capital markets from 

abuse. You must fund them appropriately, give them the legal tools they need to 

protect investors, and, most of all, hold them accountable, so that they enforce the 

laws you write. 

And finally, all regulatory reforms and improvements must be done in a coordinated and systemic way. The work of regulation is rarely done well in a piecemeal 
102 

fashion. Rather, your focus should be to create a system of rules that comprise a 

complete approach, where each part complements the other, and to do it all at once. 

Specific Reforms 

Allow me to illustrate how these principles can be put to work, in specific regulatory and policy reforms: 

First: Some have suggested that you create a single super-regulator. I would suggest that a more diverse approach should be adopted, taking advantage of the relative strengths of our existing regulatory agencies. For example, the Federal Reserve, as a banking supervisor, has a deep and ingrained culture that is oriented 

towards the safety and soundness of our banking system. But when banks—or any 

financial institution—engage in securities transactions, either by making a market 

in securities, or by securitizing and selling loans, or by creating derivatives backed 

by equities or debt, they fundamentally require oversight from trained securities 

regulators. 

What serves the health of banks may run exactly counter to the interests of investors—and we have seen situations where bank regulators have kept information 

about poorly performing assets from the public in order to give a bank time enough 

to dispose of them. In that case, banking regulators will work at cross-purposes with 

securities regulators. 

Ultimately, the only solution to that tension is to live with it. When I was at the 

SEC, there was tension between banking regulators and securities regulators all the 

time. This creative tension served the ultimate goal of reducing overall risk to our 

economy, even if it occasionally was frustrating for the regulators and the financial 

institutions themselves. And so we should not be surprised if regulatory reforms 

yield a bit of regulatory overlap. That is both natural, considering the complexity 

of financial institutions, and even desirable. 

Second: Mark to market or fair value standards should not be suspended under 

any circumstance. Some have come forward and suggested that these are unusual 

times, and we need to make concessions in our accounting standards to help us 

through it. But if we obscure investor understanding of the value of assets currently 

held by banking institutions, we would exacerbate the crisis, and hurt investors in 

the bargain. Unfortunately, recent steps taken by the FASB, at the behest of some 

politicians, weaken fair value accounting. 

Those who argue for a suspension of mark-to-market accounting argue this would 

punish risk-taking. I strongly disagree. Our goal should be to make sure risk can 

be priced accurately. 

Failure to account for risk, and failure to present it in a consistent way, makes 

it impossible to price it, and therefore to manage it. And so any effort that seeks 

to shield investors from understanding risk profiles of individual banks would, I believe, be a mistake, and contribute to greater systemic risk. 

I would add that mark-to-market accounting has important value for internal 

management of risk within a firm. Mark-to-market informs investment bank senior 

managers of trading performance, asset prices, and risk factor volatilities. It supports profit and loss processes and hedge performance analyses, facilitates the generation and validation of risk metrics, and enables a controlled environment for 

risk-taking. If treated seriously by management, mark-to-market is a force for internal discipline and risk management, not much different than a focus on internal 

controls. Yes, valuing illiquid or complex structured products is difficult. But that 

doesn’t mean the work should not be done. I would argue that it has to be done, 

both inside the firm and by those outside it, to reduce risk throughout our system. 

And so I agree with the Chairman of the Federal Reserve, and the heads of the 

major accounting firms, that the maintenance of mark-to-market standards is essential. 

Third: As this Committee and other policymakers seek to mitigate systemic risk, 

I would suggest taking a broad approach to the challenge. It would be a mistake, 

I believe, to designate only one agency to focus on systemic risk, because systemic 

risk emanates in multiple ways. You may find the task best accomplished by enacting a series of complementary regulatory enhancements aimed at promoting transparency and information discovery across multiple markets. 

Those remaining pockets of financial activity covered by self-regulation and protected from litigation should be brought in under a more vigorous regulatory structure with fully independent regulators and legal remedies. For years, credit ratings 

agencies have been able to use legal defenses to keep from the SEC from inspecting 

the way they do their ratings the way the PCAOB is empowered to examine the 

way audits are done, even though these agencies dispense investment advice and 

sit at a critical nexus of financial information and potential risk. In addition, these 

ratings agencies cannot be fined by the SEC and they operate with significant pro-
103 

tections from private rights of action. These protections from regulatory review and 

legal remedies need to be reconsidered. The credit ratings agencies have an abysmal 

record of performance in recent years and their failure has had an outsized impact 

on the health of our entire financial system. They are not merely expressing views 

that would ordinarily receive legal protections. They are playing a much larger role, 

and their activities should be treated in the same way as other market actors who 

are subject to SEC review and regulation. 

In the same manner, the SEC should have a far greater role in regulating the 

municipal bond market, which consists of state and local government securities. 

This is the market where Wall Street and Main Street collide. Since the New York 

City crisis of 1975, this market has grown to a size and complexity that few anticipated. 

It now includes not-for-profit institutions and even for-profit business corporations 

who sell securities through government conduit entities. The debt and derivative 

products sold are substantially the same as those sold in the corporate market. 

Small investors make up a substantial part of this market and because of the Tower 

Amendment many participants—insurers, rating agencies, financial advisors to 

issuers, underwriters, hedge funds, money managers and even some issuers—have 

abused the protection granted by Congress from SEC regulation. 

This market has shown that self-regulation by bankers and brokers through the 

Municipal Services Rulemaking Board all too often has come at the expense of the 

public interest. The New York City debacle in 1975, the San Diego pension fund 

fraud in 2006, the Orange County California derivatives crisis in 1994, the Washington Public Power System defaults in 1980, the auction securities settlements of 

2008, and the current investigations into derivatives, bid rigging, pay to play and 

other scandals—this is an industry prone to scandal. 

In recent months, we have even seen several well-documented scandals where 

small municipalities and public agencies were encouraged to float bonds even 

though the money was not to be spent on public purposes, but rather used as an 

investment pool. We may not want to treat municipals like we do other securities— 

but we do need to level the playing field between the corporate and municipal markets and address all risks to the financial system. Municipal issuers are ill-equipped 

and some are reluctant to do this on their own. We may have to develop ways protect small municipal issuers from over regulation just as we do for small corporations, so long as we do not develop a double standard for principles of disclosure, 

transparency, finance and compliance with market rules. Former Chairman Cox has 

suggested granting the SEC authority to regulate the municipal bond industry to 

promote integrity, competition and efficiency, and I agree. 

In addition, I would also recommend amending the Investment Advisers Act to 

give the SEC the right to oversee specific areas of the hedge fund industry and other 

pockets of what some have called the ‘‘shadow markets’’—those areas of finance beyond the oversight of regulators. In particular, I would urge that you require banks 

and hedge funds create an audit trail and clearinghouse for all trades, to create a 

better awareness of investment products that could pose risks to overall markets. 

I would also recommend placing hedge funds under SEC regulation in the context 

of their role as money managers and investment advisors. 

There will be some who argue that SEC oversight of some aspects of hedge funds 

will come at the expense of financial market innovation. In fact, such regulation 

could help improve the environment for financial innovation. For example, we know 

that new investment vehicles can be a source for risk even as they supply investors 

with a desired financial product. How do we balance those competing qualities? Perhaps the SEC could increase the margin requirement for the purchase of new products, until those products are road-tested and have developed a strong history of 

performance in different economic conditions. 

Nor are all forms of regulation going to simply involve more disclosure requirements. I could see a greater focus on better disclosure, so that investors and regulators receive information that has more value. For example, a system that allows 

financial institutions to make their own risk assessments, or relies on credit rating 

agencies for purposes of determining how much capital they should have, lacks adequate independence and credibility. At the same time, adopting a one size fits all 

approach is likely to be shortsighted and ineffective. 

As SEC Chairman, I favored risk-based principles for regulation, and think greater application of those principles is needed. Such a system should be forward-looking, independent and free of bias in its assessment of risks and liquidity needs within an entity, overseen by a regulator with a mission, culture and necessary resources to do the job, and finally, be fully transparent not only to regulators but 

also to investors, taxpayers and Congress. Such a system would be far more useful 
104 

than our current system. And it would contribute greatly to our awareness of potential sources of systemic risk. 

These steps would require OTC derivative market reform, the outcome of which 

would be the regulation by the SEC of all credit and securities derivatives. To make 

this regulation possible and efficient, it would make sense to combine the resources 

and responsibilities of the SEC and CFTC. In today’s financial markets, the kinds 

of financial instruments regulated by these two agencies share much in common as 

economic substitutes, and this change would allow regulators to share their 

skillsets, coordinate their activities, and share more information, thus providing a 

deeper level of understanding about risk. 

Supporting all these activities will require an appropriately funded, staffed and 

empowered SEC. Under the previous administration, SEC funding and staffing either stayed flat or dropped in significant areas—enforcement staff dropped 11 percent from 2005 to 2008, for example. We have seen that regulators are often overmatched, both in staffing and in their capacity to use and deploy technology, and 

they can’t even meet even a modest calendar of regular inspections of securities 

firms. Clearly, if we are to empower the SEC to oversee the activities of municipal 

bond firms and hedge funds, we will need to create not only a stronger agency, but 

one which has an adequate and dedicated revenue stream, just as the Federal Reserve does. 

My final recommendation relates to something you must not do. Under no condition should the SEC lose any of its current regulatory responsibilities. As the primary guardian of capital markets, the SEC is considered the leading investor representative and advocate. Any regulatory change you make that reduces the responsibility or authority of the SEC will be viewed as a reduction in investor protections. 

That view will be correct, because no agency has the culture, institutional knowledge, staff, and mission as the SEC to protect investors. 

Conclusion 

These actions would affirm the core principles which served the Nation’s financial 

markets so well, from 1933 to 1999—regulation meeting the realities of the market, 

accounting standards upheld and strengthened, regulators charged with serving as 

the guardians of capital markets, and a systemic approach to regulation. The resulting regulatory structure would be flexible enough to meet the needs of today’s market, and would create a far more effective screen for potential systemic risks 

throughout the marketplace. Financial innovations would continue to be developed, 

but under a more watchful eye from regulators, who would be able to track their 

growth and follow potential exposure. Whole swaths of the shadow markets would 

be exposed to the sunlight of oversight, without compromising the freedom investors 

have in choosing their financial managers and the risks they are willing to bear. 

Most importantly, these measures would help restore investor confidence by putting in place a strong regulatory structure, enforcing rules equally and consistently, 

and making sure those rules serve to protect investors from fraud, misinformation, 

and outright abuse. 

These outcomes won’t come without a price to those who think only of their own 

self-interest. As we have seen in the debate over mark-to-market accounting rules, 

there will be strong critics of strong, consistent regulatory structure. The self-interested have reasons of their own to void mark-to-market accounting, but that does 

not make them good reasons for all of us. Someone must be the guardian of the capital market structure, and someone must think of the greater good. That is why this 

Committee must draw on its heritage of setting aside partisanship and the concerns 

of those with single interests, and maintain a common front to favor the rights of 

the investor, whose confidence will determine the health of our markets, our economy, and ultimately, our Nation. 

PREPARED STATEMENT OF PAUL S. ATKINS 

FORMER COMMISSIONER, 

SECURITIES AND EXCHANGE COMMISSION

MARCH 26, 2009 

Thank you very much, Mr. Chairman, Ranking Member Shelby, and Members of 

the Committee, for inviting me to appear today at your hearing. It is an honor and 

privilege for me to provide information for your deliberations on possible legislation 

regarding the U.S. financial markets. This Committee has a long history of careful 
105 

study and analysis of matters relating to the financial markets and the financial 

services industry. 

There are multiple, complex, and interrelated causes to the current situation in 

the global financial markets. These causes have been decades in the making. Those 

who would tell you otherwise are simply misguided, have ulterior motives, or are 

unaware of the intricacies of global finance. These causes are more than the competence or incompetence of individuals in particular roles, but have more to do with 

fundamental principles of organizational behavior and incentives. 

Your topic for today is rather broad, so I would like to touch on a few specific 

items that go to the heart of an agency that I know very well—the Securities and 

Exchange Commission. I have been working in and around the SEC for all of my 

professional career. I have spent almost 10 years as a staff member and as a Commissioner. In 15 years of private practice I have applied the Commission’s regulations in transactions and in real business situations. In the course of my work, I 

have interacted with every one of the SEC’s divisions and offices in one way or another. 

With respect to the subject of regulatory reform, I would suggest that you ask 

very hard questions in subsequent hearings: For example, why has the SEC in the 

course of the past dozen years or so experienced catastrophic failures in every one 

of its four core competencies—rulemaking, filing review, enforcement, and examinations? What led to failures at the SEC and other regulatory agencies—both in the 

United States and globally—to discern the increasing risk to financial institutions 

under their jurisdiction? What led to failures at financial institutions to recognise 

the inadequacy of their own risk management systems and strategy in time to avert 

a collapse? How did many investors get lulled into complacency and not adequately 

do their own due diligence? What is the proper role of credit rating agencies, and 

has regulation fostered an oligopoly by recognizing the opinions of a few as being 

more privileged than the rest? 

Your challenge in formulating laws and regulations is that every action leads to 

a reaction, just as in physics. Just as investors should know that there is no riskless 

or easy way to make money, policymakers should know that there is no riskless or 

easy way to oversee the financial markets. I respectfully submit that changes to the 

securities laws should be made carefully and with the knowledge that modern financial services is a quickly evolving industry. Sooner or later the markets will stabilize, depending on what actions governments take. The goal should be a balance, 

using the facts as they best can be discerned, through a robust analysis of the costs 

and benefits of various potential actions and how those actions might affect human 

behavior. The current situation is certainly no time to ‘‘wing it’’ or act on ‘‘gut’’ instinct. The weighing of costs and benefits is vital, because investors ultimately pay 

for regulation. If regulations impose costs without commensurate benefits, investors 

suffer the costs of lack of effectiveness and efficiency, not only through higher prices 

but also through constrained investment opportunities. That ultimately hurts them 

in their investment performance, because it means less opportunity for diversification. 

Why should we care about the capital markets? Despite all of the recent gloomy 

and tragic news of the past couple of years, we must not forget that one of the most 

important underlying purposes of our capital markets is to allow entrepreneurs with 

great new ideas to make their dreams possible by raising capital, thereby helping 

the economy grow by creating jobs, improving the lives of consumers through producing innovative products, and providing a return to investors who have risked 

their savings to help finance that entrepreneur’s dream. This is the role—and genius—of the United States capital markets that has helped our economy to be the 

engine of the world’s growth and made our standard of living the best in the world. 

Notwithstanding the current economic conditions, I feel confident that the role of 

the United States capital markets will return to what it was, barring ill-advised legislation or regulatory actions. An example of legislation that had a detrimental effect on the attractiveness of U.S. markets was the so-called Interest Equalization 

Tax, a short-lived tax imposed in 1963 on borrowing by U.S. and foreign companies 

in the U.S. The goal was to encourage capital to stay in this country and to equalize 

the costs between selling debt and equity securities. It essentially backfired when 

U.S. companies found that they could issue dollar-denominated debt in London, 

avoiding the tax and increasing yields. The London markets, which had yet to fully 

recover after World War II, experienced a boom in size and credibility that eventually led them to eclipse the U.S. in some benchmarks by 2007. 

We should not forget that just prior to the recent problems in the credit markets, 

which began more or less in June 2007 when a small fund was closed to redemptions, setting off a world-wide reassessment of the creditworthiness of U.S. housingrelated debt securities, public offerings of securities in the United States were on 
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the decline, compared to offerings in the private markets. In fact, in 2006, the value 

of Rule 144A unregistered offerings in the U.S. for the first time exceeded the value 

of public offerings. 

All of this is to suggest that Congress be especially deliberative and pragmatic 

in legislating in this area. The worrisome thing to me is that if care is not taken 

to have solid analysis, the wrong lessons may be gleaned from this latest crisis that 

hurt investors. It takes a long time to change legislation in this area. We still have 

not dug ourselves out of some of the mistakes and false premises that drove the decision making during the 1930s and 1940s. For example, it took 40 years for Congress and the SEC to end fixed commissions for brokerage services that were essentially imposed by law in the 1930s, and we still have many aspects of the so-called 

‘‘managed competition’’ philosophy that led to that policy. We still have the alphabet 

soup of regulators and self-regulatory organizations in the financial services industry, with all of the distortions and inefficiencies that have contributed to the current 

crisis and become so painfully evident to the world. Many have complained about 

this situation for years, but others have opposed any restructuring as ‘‘dangerously 

deregulatory,’’ and ignored the inherent systemic risks, overlapping jurisdiction, turf 

wars, and wasted resources of the current structure. 

In the wake of the stock market crash of 1929, over the next decade this Committee and others held many hearings and explored the abuses in the marketplace 

including conflicts of interest, shady transactions with affiliates, less-than-adequate 

disclosure, and squirrelly valuations. Congress responded by passing the Securities 

Act of 1933, the Securities Exchange Act of 1934, the Public Utility Holding Company Act of 1935 (‘‘PUHCA’’), the Trust Indenture Act of 1939, the Investment Advisers Act of 1940, and the Investment Company Act of 1940, among other laws. 

Many provisions of these laws were helpful to the market and to investors and 

stood the test of time. But, as time passed, it became clear that some laws were 

counter-productive. For example, by the end of the 20th century, PUHCA was cited 

as a reason for a relative paucity of investment in the electric and gas utility industry. In fact, for the first 25 years of its existence, the SEC’s main task was to break 

up interstate investor-owned electric and gas utilities by using PUHCA. This was 

the investment management division’s primary job, and more people were devoted 

to this mission than any other at the SEC for more than 20 years. By the end of 

the 1950s, this mission was mostly accomplished. Finally, Congress repealed 

PUHCA in 2006. 

What lesson can we draw from PUHCA? Congress passed the Act because of the 

self-dealing and manipulation concerning interstate utility holding companies in 

the1920s. Instead of focusing on the problematic practices and addressing them directly, Congress reshaped the entire industry. What were the unintended consequences? After repeal, for example, alternative energy technologies are easier to 

finance. In addition, What would our power industry be like today if a different legislative strategy had been pursued originally? What would our capital markets be 

like today if the SEC had spent more of its energy for those three decades focusing 

on more general problems of the capital markets? 

Forthright Analysis Needed 

Certainly, many mistakes were made by business people, investors, and regulators during the past decade, but too many these days are looking in hindsight to 

pass judgement or blame. What we need is an analysis to determine how we can 

efficiently and effectively promote honesty and transparency in our markets and ensure that criminality is not tolerated. 

For example, some have claimed that ‘‘deregulation’’ over the past 4, 8, or 10 

years has led to the current problems in the financial markets. One can hardly say 

that the past 8 to 10 years have been deregulatory. The enactment of the SarbanesOxley Act in 2002 led to the promulgation by the SEC of more rules in a shorter 

amount of time than ever before. In addition, the last 7 years have seen many new 

SEC and self-regulatory organization rules regarding compliance and trading, which 

have certainly been very regulatory. The Financial Accounting Standards Board, the 

Public Company Accounting Oversight Board (‘‘PCAOB’’), and the Municipal Securities Rulemaking Board have promulgated a host of new rules, standards, and interpretations. 

This attitude that blames our current problems on ‘‘deregulation’’ is not only completely wrong, but dangerous because it is off the mark. If that is what policy makers think is the reason for the current situation, then they will have learned the 

wrong lesson and their solutions will cause more problems than they will solve. 

More regulation, for regulation’s sake, is not the answer. We need smarter regulation. Some say that we need to trust less in the marketplace and more in the capabilities of regulators, including a putative ability to foresee bubbles and intervene 
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to stop them. That is much easier said than done. This assertion ignores the reality 

that what may seem to be a bubble to one person may be another person’s honest 

livelihood. What if the regulator is wrong? How will you ever know the opportunity 

cost to individuals or to society as a whole for curtailing some particular activity? 

It is always easier in hindsight to say what should have been done. How can you 

build public policy for years in the future on hoped-for brilliance or luck of individual, fallible human beings, especially if they are independent, nonelected, and essentially unaccountable? 

This global crisis has primarily affected regulated (versus nonregulated) entities 

all around the world, not just in the supposedly deregulatory United States. How 

did so many regulators operating under vastly different regimes with differing powers and requirements all get it wrong? Indeed, how did so many firms with some 

of the best minds in the business get it wrong? The housing bubble occurred in the 

US as well as the United Kingdom, Ireland, and Spain. Heavily regulated financial 

institutions had problems with their housing-related investments not only in the US 

but also in Germany, Switzerland, France, Belgium, Netherlands, Ireland, the 

United Kingdom, and many others. 

We must recognize that businesses ultimately are better than governments at 

business, because both can and do make mistakes. In addition, by removing risk 

management from firms and placing it in the hands of government, there is a danger that firms will become careless and take on additional risk, believing regulators 

are protecting them. If they believe that the government is backstopping their 

losses, then they may take greater risks, reap the rewards of taking those risks, and 

avoid the consequences if things go awry. This is the moral hazard that we all try 

to avoid. Regulators have a legitimate interest in setting capital standards to control 

this risk taking, but the ultimate risk management function must remain in the 

hands of the firms that face the risk. 

What Caused the SEC’s Operational Failures? 

During the past dozen years, the SEC has experienced catastrophic operational 

failures in its four core functions of filing review, rulemaking, enforcement, and examinations. Enron’s corporate filings were not reviewed for years in the late 1990s; 

Congress addressed this issue in Sarbanes-Oxley by mandating that the SEC review 

each issuer’s filings on a periodic basis. In enforcement and examinations, tips were 

not pursued regarding Bernard Madoff and late trading of mutual funds. In rulemaking, the Commission proposed in December 1997 and again in April 2005 regulations regarding credit rating agencies, but never adopted any. This Committee led 

the effort to reform the SEC’s approach to nationally recognized statistical rating 

organizations (‘‘NRSROs’’) that culminated in the Credit Agency Reform Act of 2006, 

but unfortunately this statute came too late to affect the crisis in the financial markets and the 30-year history of NRSRO regulation. 

The SEC to its credit and benefit has attracted many hard-working, bright, energetic staff members over its history. But, these mistakes were caused by failures of 

senior management, rather than by staff members. First, management applied 

faulty motivational and review criteria. Second, since resources are always limited, 

there is an opportunity cost in choosing to spend time and resources on one thing, 

because there is less time and fewer resources to spend on other things. Unfortunately, the SEC suffered from poor prioritization decisions during the critical years 

of 2003–2005 when the market for collateralized debt obligations and credit default 

swaps started to explode and its trajectory could have been diverted. 

Some argue that low pay or poor morale contributed to these failures. Thanks to 

this Committee through the Sarbanes-Oxley Act, pay caps were removed from SEC 

staff pay in 2002. When I left the SEC, more than half of the 3,500 employees 

earned more than I did as a commissioner and many earn more than the chairman. 

Today, a staff attorney or accountant (SK-14) earns nearly $168,000 in Washington, 

DC ($177,000 in New York), and senior managers earn well in excess of $200,000. 

As with anyone else, I am sure that SEC employees would like more pay, but how 

much should they be paid? As much as PCAOB board members, who earn more 

than the President? As with most government employees, the vast majority of SEC 

employees go to work because they like their job and they are committed to the 

agency’s mission. In addition, they have job security and other benefits that cannot 

be duplicated in the private sector. 

Management Failures. Management philosophies like Total Quality Management 

and Six Sigma teach that in any organization, measurement drives human behavior 

because the incentive is to try to meet the measurement criteria (‘‘You get what you 

measure’’). 

Essentially, Enron was not reviewed for years because review personnel were 

judged by how many filings they reviewed, not necessarily by the quality of their 
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1See Paul S. Atkins and Bradley J. Bondi, ‘‘Evaluating the Mission: A Critical Review of the 

History and Evolution of the SEC Enforcement Program,’’ 8 Fordham Journal of Corp. & Fin. 

Law 367 (2008). 

review. The incentive was to postpone review of the complicated Enron filing because one could review many others in the time it would take to review Enron. By 

the late 1990s, this focus on numbers more than quality had decreased staff morale 

so much that employees began to organize to form a union. Despite management’s 

campaign to thwart it, in July 2000 SEC employees voted overwhelmingly to 

unionize the workforce. 

The emphasis on numbers over quality also affects behavior in the enforcement 

division and examination office. Every enforcement attorney knows that statistics 

(or ‘‘stats’’) help to determine perception and promotion potential. The statistics 

sought are cases either brought and settled or litigated to a successful conclusion, 

and amount of fines collected. These statistics do not necessarily measure quality 

(such as an investigation performed well and efficiently, but the evidence ultimately 

adduced did not indicate a securities violation). Thus, the stats system does not encourage sensitivity to due process. 

In addition, the stats system tends to discourage the pursuit of penny stock manipulations and Ponzi schemes, which ravage mostly retail investors. These frauds 

generally take a long time and much effort to prove—the perpetrators tend to be 

true criminals who use every effort to fight, rather than the typical white-collar corporate violator of a relatively minor corporate reporting requirement who has an incentive to negotiate a settlement to put the matter behind him and preserve his reputation and career. Thus, over the years several staff attorneys have told me that 

their superiors actively discourage them from pursuing Ponzi schemes and stock 

manipulations, because of the difficulty in bringing the case to a successful conclusion and the lack of publicity in the press when these cases are brought (with the 

exception of Madoff, these sorts of cases tend to be small). Some senior enforcement 

officers openly refer to these sorts of cases as ‘‘slip-and-fall’’ cases, which disparages 

the real effect that these cases have on individuals, who can lose their life savings 

in them. Because of the interstate and international aspect of many of these cases, 

if the SEC does not go after them, no one can or will. 

During my tenure as commissioner, I emphasized the need to focus from an enforcement perspective on microcap fraud, including Ponzi schemes, pump-and-dump 

schemes, and other stock manipulations. I was a strong advocate for the formation 

of the Microcap Fraud Group in the Enforcement Division, which as finally formed 

in 2008. I also strongly support the good efforts of the Office of Internet Enforcement, established under Chairman Levitt in the late 1990s, which works closely 

with other law enforcement agencies to tackle internet and other electronic fraud. 

There are many intelligent, competent, dedicated, hard-working people at the 

SEC. It is the management system and how it determined priorities over the past 

decade that has let them down. Last year in an article published in the Fordham 

Journal of Corporate and Financial Law, 1 I called for the SEC to follow the example 

from 1972 of Chairman William Casey, who formed a committee to review the enforcement division—its strategy, priorities, organization, management, and dueprocess protections. Thirty-seven years later, and especially after the Madoff incident, this sort of review is long overdue. 

The Opportunity Cost of Misplaced Priorities. I believe that the SEC was distracted by controversial, divisive rulemaking that lacked any grounding in cost-benefit analysis during a critical period. In 2003–2005, the agency pushed through 

three controversial rules regarding mutual fund governance, hedge fund registration, and the so-called National Market System rules. In these cases, the SEC did 

not conduct an adequate analysis of the costs versus the benefits of these proposed 

rules. The hedge fund and mutual fund rules were invalidated by the courts after 

long litigation and much distraction for the agency and the industry. In each of 

these cases, former Commissioner Cynthia A. Glassman and I offered alternatives 

and compromises, but we were presented with a take-it-or-leave-it choice that left 

no alternative but dissent. 

These controversies now sound rather trivial in light of the current situation in 

the financial markets. However, important legal principles were involved, including 

lack of authority to promulgate the hedge fund rule and lack of observing a legislative mandate for analyzing costs and benefits in connection with the mutual fund 

governance rule. Hedge funds ultimately were not the problem in the current financial crisis; risk management at regulated entities was the problem. Moreover, Regulation NMS cost the securities industry more than $1.5 billion to try to implement 

a rule to address a theoretical problem that did not exist. Ultimately, after much 
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effort and distraction, many exemptions and exceptions have been issued by the 

SEC staff that effectively have gutted the rule. 

Because life is full of choices, if you devote resources to one thing, you have less 

to devote to another. And, the one risk that you have not focused on just may blow 

up in your face. 

That, in fact, is just what happened to the SEC. During this critical 2003–2005 

time period when so much effort was wasted on these quixotic detours, the market 

for collateralized debt obligations (CDOs) and credit default swaps (CDSs) was taking off. 

What might the SEC have done, had it not been so distracted by other false priorities? Sometimes the issues are a lot more basic than we think. With respect to 

CDOs and CDSs, the SEC did not have jurisdiction to regulate them as instruments. But, one of the critical factors that developed as market interest in them 

grew was the inadequate documentation for these OTC derivatives. While the SEC 

was trying to devise complex solutions to nonexistent problems, it neglected a real 

risk management issue in the fundamental infrastructure that enables the markets 

to work smoothly. For example, in the failure of the hedge fund Amaranth in 2006, 

I was told that it took a couple of hundred people several weeks to sort through 

the OTC derivatives documentation issues and figure out valuation. One of the primary difficulties has been the lack of standardized documentation, which has often 

resulted in lengthy confirmations. At the time, I and others had called for this to 

be addressed. I am happy that the industry and regulators are making progress in 

this area. 

The incomplete and inaccurate documentation in this area was a legitimate risk 

management issue, especially since no centralized, automated trade processing existed for these instruments. As we have witnessed over the past year, valuation is 

a challenge, because these instruments are complicated and not standardized. Novations create a huge challenge to follow the chain of ownership. 

Proposals for Financial Services Reform 

Several general proposals have been made recently for structural reforms to the 

financial services regulatory framework. Since these have not yet become concrete 

proposals, I have a few general comments in this regard. 

Systemic Risk Regulator. This concept was raised last year in the Treasury Department’s Blueprint for a Modernized Regulatory Structure. As a theory, it has 

some general appeal, but as a practical matter it raises many questions. Just who 

would be the systemic risk regulator? The Treasury, the Federal Reserve, some 

newly created entity, or a council of regulators (such as the President’s Working 

Group)? What would its powers be? Would it be a merit regulator of new products? 

If it is the Treasury, what would its role be with respect to other independent agencies? 

Issues of systemic risk can be raised in many different contexts. For example, in 

the 1990s, the Federal Reserve and the SEC disagreed over the levels of loan loss 

reserves taken by certain banks. The Fed argued on the basis of safety and soundness concerns, and the SEC was worried about earnings management and disclosure. 

Merit regulation of new products is always problematic, because a government 

agency is making determinations for investors as to appropriateness. What standards would the systemic regulator use to vet the new products? The time for review 

adds to the cost of the new products and adds to uncertainty 

Although the federal rules with respect to public offerings of securities are based 

on disclosure, some states have a merit-regulatory regime. An illustrative example 

of how government officials can make incorrect determinations, with the best intentions of investor protection, is the initial public offering of Apple Computer. The 

SEC approved Apple’s registration statement under the federal Securities Act, but 

Massachusetts prohibited the offering of Apple shares because they were ‘‘too risky.’’ 

Texas approved the sale after an extensive review, but its securities regulator called 

his decision ‘‘a close call,’’ and Apple did not even bother to offer its shares in Illinois due to strict state laws on new issues. The subsequent performance of Apple 

stock is a matter of history. 

With respect to CDOs and CDSs, would a systemic regulator have identified the 

potential problems of documentation and trading? 

Merger of the SEC and CFTC. If this merger is to be effected, it should be done 

with care. The statutes and rules governing the securitie 

s and futures markets are different, and the approaches that the two agencies 

take are different. The futures markets are mostly dealer markets, while the securities markets have a large retail investor component. A merger cannot simply be the 

combining of two agencies under one roof; it would be a complicated task. 
110 

Short of merger, Congress could help by laying out guidelines for the two agencies 

to resolve conflicts regarding products that have indicia of both securities and futures. This issue has existed since the 1980s, and the two agencies have periodically 

tried to address the conflicts. In fact, this issue would still exist even if the agencies 

were combined, just as issues exist between SEC divisions. 

Credit Rating Agencies. Thanks to the hard work of this Committee, Congress 

passed the Credit Rating Agency Reform Act of 2006, which set out a regulatory 

regime for the SEC’s staff-designated NRSROs through a frustratingly slow process 

that had the effect of limiting competition in issuing credit ratings. The 2006 legislation made the application process speedier and more transparent. 

The subprime problems made it clear that many investors relied on credit ratings 

without performing their own due diligence. Government agencies relied on credit 

ratings to their detriment as well. Even if conflicts of interest are addressed and 

fully disclosed, we still have the problem that opinions of certain institutions are 

given great regulatory weight. Thus, few realized the great systemic risk inherent 

in the holdings of CDOs by financial institutions, because they were deemed to be 

the highest-rated instruments. Over the past 30 years or so, references to NRSRO 

ratings have become embedded in many federal and state statutes and SEC and 

other agency rules. Has this created a perception that the government endorses the 

process by which NRSROs produce their ratings? That would be an incorrect perception; the SEC or any government agency can never be equipped to assess the quality 

of NRSRO ratings or the procedures by which they are devised. I would argue that 

it would be a mistake to ask any government agency to attempt to do so. Is it time 

to remove these ratings from our statutes and rulebooks? Can we create alternatives 

to this flawed system that accords undue weight to informed, albeit potentially 

flawed, opinions? 

The rating agency industry over the years had become an oligopoly—three large 

firms control 90 percent of the market, and two of them control 80 percent. This 

concentration was a direct result of a nontransparent, arcane SEC oversight system. 

The consequence was a lack of competition and lack of new entrants. For example, 

a non-U.S. rating agency waited 16 years before its application was finally approved. The 2006 enactment of the Credit Rating Agency Reform Act directed the 

SEC to open up the process, encourage competition, and increase transparency and 

oversight of the credit rating firms to protect against conflicts of interest. Would 

more voices in the rating industry have averted the problems with ratings of structured products? 

SEC Strategic and Risk Assessment. Congress should encourage Chairman 

Schapiro to engage in a thorough strategic and risk assessment, especially if the 

agency is to receive more resources and authority. In the past 10 years, the agency’s 

budget has more than doubled and its staffing has increased commensurately. However, the internal organization and management structure is essentially the same. 

Would today’s crisis have occurred if the SEC had had a real risk evaluation capability? Former Chairman Harvey Pitt undertook an extensive review of the SEC’s 

organization and functionality in 2001 with a view to modernize it. He conceived 

of a risk assessment office that would work closely with the operating divisions. The 

plan was to give it its own personnel, but also to have personnel seconded to it in 

order to generate buy-in from the operating divisions. Unfortunately, when his successor established the office, it did not have adequate resources and it did not have 

any secondments. Thus, the group was not integrated into the flow of the agency’s 

operations and became an orphaned group filling a niche role with very limited effectiveness. 

In addition, should the examination function continue in its current form? In the 

aftermath of the Madoff affair, the structure and function of the Office of Compliance Inspections and Examinations should be reviewed. If Congress chooses to require that hedge funds and private equity firms register as advisors under SEC 

oversight, the burden added to the agency’s examiners would be enormous. The current paradigm of periodic inspections of funds by government examiners cannot endure, unless the agency increases tremendously in size, inevitably leading to more 

managerial problems. One solution could be to re-integrate the examination function 

into the operating divisions and to establish the opportunity for registered advisors 

to submit to independent reviews, which would be overseen by the SEC. 

In conclusion, regulation of financial markets needs to be modernized and rationalized. But, it must be done in an informed way, taking into account costs and benefits and being mindful of potential unintended consequences. Financial markets are 

global, integrated, and quickly changing, and the legislative process is not as responsive. I stand ready to assist the Committee going forward as you deliberate 

these issues and if you develop any legislation. 
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Thank you again for extending me the privilege of appearing before you today. 

You have a momentous task before you. I wish you all the best in your work. 
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PREPARED STATEMENT OF RICHARD G. KETCHUM 

CHAIRMAN AND CHIEF EXECUTIVE OFFICER, 

FINANCIAL INDUSTRY REGULATORY ASSOCIATION

MARCH 26, 2009 

Chairman Dodd, Ranking Member Shelby, and Members of the Committee: I am 

Richard Ketchum, Chairman and CEO of the Financial Industry Regulatory Authority, or FINRA. On behalf of FINRA, I would like to thank you for the opportunity 

to testify today. 

I commend you, Mr. Chairman, for holding today’s hearing on the critically important topic of reforming our regulatory structure for financial services. As someone 

who has spent the great majority of my career as a regulator, dedicated to protecting investors and improving market integrity, I am deeply troubled by our system’s recent failures. 

The credit crisis and scandals of the last year have painfully demonstrated how 

the gaps in our current fragmented regulatory system can allow significant activity 

and misconduct to occur outside the view and reach of regulators. The fallout of this 

has been massive, and for many investors, tragic. Investor protection is the core of 

FINRA’s mission, and we share your commitment to identifying existing regulatory 

gaps and weaknesses as well as changes to the regulatory framework that would 

close those gaps and improve the system for all investors. 

FINRA 

FINRA was created in 2007 through the consolidation of NASD and the member 

regulation, enforcement, and arbitration divisions of the New York Stock Exchange. 

With a staff of 2,800, FINRA regulates the practices of nearly 4,900 firms, about 

174,000 branch offices and more than 650,000 registered securities representatives. 

As an independent regulatory organization, FINRA provides the first line of oversight for broker-dealers. 

FINRA augments and deepens the reach of the federal securities laws with detailed and enforceable ethical rules and a host of comprehensive regulatory oversight programs. FINRA admits to and excludes from the industry both firms and 

individuals; adopts and enforces rules to protect investors and the financial markets; examines broker-dealers for compliance with its own rules as well as federal 

securities laws and rules of the Municipal Securities Rulemaking Board (MSRB); informs and educates the investing public; provides industry utilities and administers 

the largest dispute resolution forum for investors and registered firms. Significantly, 

FINRA is funded by regulatory fees—not taxpayer dollars. Yet FINRA’s Board of 

Governors is comprised of a majority of nonindustry representatives. The uniquely 

balanced structure of our Board ensures a paramount focus on investor protection 

and the opportunity for input from a diverse variety of perspectives. 

FINRA’s Core Investor Protection Programs 

Examinations 

FINRA has a robust and comprehensive examination program with dedicated resources of more than 1,000 employees. Routine examinations are conducted on a 

regular schedule that is established based on a risk-profile model. This riskprofile 

model is very important: It permits us to focus our resources on the sources of most 

likely harm to average investors. We apply our risk-profile model to each firm, and 

our exams are tailored accordingly. In performing its risk assessment, FINRA considers a firm’s business activities, methods of operation, types of products offered, 

compliance profile and financial condition, among other things. 

During routine examinations, FINRA examines a firm’s books and records to determine if they are current and accurate. Sales practices are analyzed to determine 

whether the firm has dealt fairly with customers when making recommendations, 

executing orders and charging commissions or markups and markdowns. Antimoney 

laundering, business continuity plans, financial integrity and internal control programs are scrutinized. 

In addition, FINRA conducts more narrow examinations based on information 

that we receive, including investor complaints, referrals generated by our market 

surveillance systems, terminations of brokerage employees for cause, arbitrations 

and referrals from other regulators. In 2008, FINRA conducted almost 2,500 routine 

examinations and nearly 6,500 targeted examinations. 

Enforcement 

FINRA’s Enforcement Department is dedicated to vigorous and evenhanded enforcement of the federal securities laws and FINRA and MSRB rules. FINRA brings 
163 

disciplinary actions against firms and their employees that may result in sanctions 

ranging from cautionary actions for minor offenses to fines, suspensions from the 

business and, in egregious cases, expulsion from the industry. FINRA frequently requires firms to provide restitution to harmed investors and often imposes other conditions on a firm’s business to prevent repeated wrongdoing. 

In 2008, FINRA issued 200 formal complaints and 1,007 decisions were issued in 

formal disciplinary cases. FINRA collected over $28 million in fines, either ordered 

or secured agreements in principle for restitution in excess of $1.8 billion, expelled 

or suspended 19 firms, barred 363 individuals from the industry and suspended 321 

others. Over the past decade, FINRA issued 12,158 decisions in formal disciplinary 

cases, expelled or suspended 208 firms and barred or suspended 7,496 individuals. 

Registration, Testing, and Continuing Education 

Persons employed by a broker-dealer that engage in a securities business must 

register with FINRA. As part of the registration process, applicants must disclose 

their prior employment and disciplinary history, since certain prior conduct may 

prevent registration. FINRA also develops and administers qualification examinations that securities professionals must pass to demonstrate competence in the areas 

in which they will work. FINRA further administers a continuing education program that every registered person must satisfy. FINRA administers 28 qualifications exams to over 275,000 people every year, including examinations that support 

the MSRB, States and National Futures Association programs. 

FINRA maintains the Central Registration Depository (CRD), the central licensing and registration system for the U.S. securities industry and its regulators. CRD 

contains the qualification, employment and disciplinary histories of firms and brokers, making it the world’s largest and most sophisticated online registration and 

reporting system. 

FINRA’s BrokerCheck system makes publicly available, free of charge, certain information about firms and brokers, including disciplinary histories that can inform 

an investor’s decision as to which firm or broker to use. 

FINRA also developed, for the SEC, the Investment Adviser Registration Depository, a utility that allows federal- and state-regulated investment advisers to satisfy 

mandated licensing requirements. FINRA makes information about investment adviser firms publicly available. 

Under contract with the Conference of State Bank Supervisors, FINRA also developed the Nationwide Mortgage Licensing System (NMLS). NMLS is a webbased system that allows state-licensed mortgage lenders, mortgage brokers and loan officers 

to apply for, amend, update or renew licenses online for participating state agencies 

using a single set of uniform applications. Twenty-three states are currently participating in the NMLS system. Encouraged by the passage of the Housing and Economic Recovery Act of 2008, 10 additional states plan to participate in the system 

during 2009; 14 more have indicated plans to participate beginning in 2010. 

Advertising 

FINRA operates an extensive program to ensure that communications by firms to 

the public are not misleading. FINRA rules require that advertisements, Web sites, 

sales brochures and other communications present information in a fair and balanced manner. Some communications-those related to mutual funds, variable products and options, for example-must be filed with FINRA. In 2008, FINRA reviewed 

more than 99,000 pieces of communication and completed 476 investigations involving 2,378 separate communications. 

Investor Education 

Investor education is a critical component of investor protection and FINRA is 

uniquely positioned to provide valuable investor education primers and tools. 

FINRA sponsors numerous investor forums and outreach programs, and its Web site 

(www.finra.org) is a rich source of such material, including investor alerts, unbiased 

primers on investing and interactive financial planning tools. 

In addition to the investor education activities of FINRA itself, the FINRA Investor Education Foundation is the largest foundation in the United States dedicated 

to investor education. Its mission is to provide underserved Americans with the 

knowledge, skills and tools necessary for financial success throughout life. The 

Foundation awards grants to fund educational programs and research aimed at segments of the public who could benefit from additional resources. Since the FINRA 

Foundation’s inception in December 2003, it has approved more than $45 million 

in financial education and investor protection initiatives through a combination of 

grants and targeted projects. Many of those initiatives have focused on particularly 

vulnerable investors, such as seniors and military personnel and their families. 
164 

Gaps in the Current Regulatory System 

While regulators continue to look back and attempt to unravel the events and 

scandals of the past year, all of us must move ahead to aggressively revamp and 

modernize the regulatory framework. The failures that have rocked our financial 

system have laid bare the regulatory gaps that must be fixed if investors are to have 

the confidence to re-enter the markets. There are critical questions that should be 

considered as part of any new regulatory approach. 

First, what protections should be provided to investors? Our current system of financial regulation leads to an environment where investors are left without consistent and effective protections when dealing with financial professionals. Investors 

deserve a system where they can be confident they will receive certain basic protections regardless of what product they buy or what license their financial professional holds. At the very least, our system should provide investors with the following protections: 

• every person who provides financial advice and sells a financial product should 

be tested, qualified and licensed; 

• the advertising for financial products and services should be subject to requirements that it is not misleading; 

• every product marketed to a particular investor is appropriate for recommendation to that investor; and 

• there should be full and comprehensive disclosure for the services and products 

being marketed. 

Unfortunately, not all financial products come with these important attributes or 

protections. 

Second, what products, activities and services should be regulated, and how? 

There are a number of gaps across our system, both in terms of similar products 

and services being regulated quite differently. Where we can identify these regulatory gaps that compromise investor protection and pose risk to the financial system, they should be thoughtfully filled. 

One example is hedge funds. Hedge funds play a significant role in the financial 

system, but they are an unregulated part of it. The absence of transparency about 

hedge funds and their investment positions is a concern. First, as we have seen from 

the recent redemptions by fund investors and the de-leveraging of funds in response, 

they have significant ability to directionally move markets. Secondly, such funds are 

significant traders of over-the-counter derivative products that are unregulated and 

system regulation requires an understanding of these positions by regulators. Finally, although these funds are generally marketed only to investors deemed sophisticated, public pension funds, endowments and other fiduciary-type funds have exposure to hedge funds and absent some level of regulation, we cannot gain comfort 

that only investors with the appropriate risk tolerances and sophistication are invested in these unregulated vehicles. 

Apart from their use by any class of investor or type of fund, over-the-counter 

(OTC) derivatives need much greater regulatory consideration. As trading in the 

credit default swap market has demonstrated, derivative trading can have tremendous impact on the pricing of the underlying security or index. The lack of transparency and the potential impacts these products can have on regulated markets 

and the broader financial system is cause for concern. Some of these products allow 

substantial leverage that directly interacts with and impacts equity and debt markets. For instance, positions in OTC derivatives can impact the viability of brokerdealers through freezing their funding even when positions in those products are 

booked in other parts of the holding company. In addition, many OTC derivatives 

encounter great counterparty settlement risk because they do not clear through an 

established centralized clearing system that greatly reduces the risk of default in 

the settlement of contractual obligations. FINRA is pleased to have filed a proposed 

margining structure with the Securities and Exchange Commission that would enable its regulated firms that are members of the Chicago Mercantile Exchange to 

settle credit default swaps through that exchange’s newly developed central clearing 

system for those products. 

Finally, I’d like to highlight the regulatory gap that, in our view, is among the 

most glaring examples of what needs to be addressed in the current system-the disparity between oversight regimes for broker-dealers and investment advisers. The 

lack of a comprehensive, investor-level examination program for investment advisers 

impacts the level of protection for every member of the public that entrusts funds 

to an adviser. 

In fact, the Madoff Ponzi scheme highlighted what can happen when a regulator 

like FINRA has only free rein to see one side of a business. Fragmented regulation 
165 

provides opportunities to those who would cynically game the system to do so at 

great harm to investors. 

So what can be done to try to prevent this from happening in the future? The 

regulatory regime for investment advisers should be expanded to include an additional component of oversight by an independent regulatory organization, similar to 

that which exists for broker-dealers. 

The SEC and state securities regulators play vital roles in overseeing both brokerdealers and investment advisers, and they should continue to do so. But it’s clear 

that dedicating more resources to regular and vigorous examination and day-to-day 

oversight of investment advisers could improve investor protection for their customers, just as it has for customers of broker-dealers. 

As the SEC has noted, the population of registered investment advisers has increased by more than 30 percent since 2005. Investment advisers now number 

11,300-more than twice the number of broker-dealers. While the SEC has attempted 

to use risk assessment to focus its resources on the areas of greatest risk, the fact 

remains that the number and frequency of exams relative to the population of investment advisers has dwindled. Consider the contrast: FINRA oversees nearly 

4,900 broker-dealer firms and conducts approximately 2,500 regular exams each 

year. The SEC oversees more than 11,000 investment advisers, but in 2007 conducted fewer than 1,500 exams of those firms. The SEC has said recently that in 

some cases, a decade could pass without an examination of an investment adviser 

firm. 

There are differences in the current rules and standards that apply to 

brokerdealers and investment advisers, reflective of some of the differences that 

exist in the services provided by each class of professionals. And while the two channels have converged over the years, there remain some differences that need to be 

taken into account when enhancing oversight and exams to make that oversight fit 

the activity and services in each. 

Broker-dealers are subject to a very detailed set of rules established and enforced 

by FINRA that pertain to safety of customer cash and assets, advertising, sales 

practices, limitations on compensation, financial responsibility, and trading practices. FINRA ensures firms are following the rules with a comprehensive examination and enforcement regime. 

Investment advisers are subject to provisions of the Investment Advisers Act of 

1940 that pertain to registration, disclosure, record-keeping, custody and compensation. Importantly, investment advisers are also subject to a fiduciary standard with 

regard to their clients. In designing a more regular oversight and examination program for investment advisers, these rules and standards should be taken into account. 

Simply put, FINRA believes that the kind of additional protections provided to investors through its model are essential. Does that mean FINRA should be given 

that role for investment advisers? That question ultimately must be answered by 

Congress and the SEC, but FINRA is uniquely positioned from a regulatory standpoint to build an oversight program for investment advisers quickly and efficiently. 

We have a strong track record in our examination and enforcement oversight, as 

well as in our other core programs. Certainly in the registration area, with regard 

to investment advisers and mortgage brokers, we have two success stories of adapting our infrastructure to meet needs in areas beyond the realm of broker-dealers. 

In FINRA’s view, the best oversight system for investment advisers would be one 

that is tailored to fit their services and role in the market, starting with the requirements that are currently in place for advisory activity. Simply exporting in wholesale fashion the broker-dealer rulebook or current governance would not make 

sense. That said, as I noted earlier, where applicable, we do believe that enhanced 

regulatory consistency is in the best interest of investors, especially in the four 

areas I mentioned-licensing, advertising, sales practice and disclosure. 

We believe that regular and frequent exams are a vital component of effective 

oversight of financial professionals, and that the absence of FINRA-type oversight 

of the investment adviser industry leaves investors without that critical component 

of protection. In our view, it simply makes no sense to deprive investment adviser 

customers of the same level of oversight that broker-dealer customers receive. And 

quite simply, as we learned from the Madoff scandal, it would not make sense for 

two, separate independent regulatory bodies to oversee investment advisers and 

broker-dealers, especially when they exist in the same legal entity. Again, there 

would be no single regulator with a complete picture of the business. 

One of the primary issues raised about investor protection differences between the 

broker-dealer and investment adviser channels is the difference between the fiduciary standard for investment advisers and the rule requirements, including suitability, for broker-dealers. As this the process moves forward, this is the kind of 
166 

issue that should and will be on the table as we all look at how best to reform our 

regulatory system and strengthen investor protections. In keeping with our view 

there should be increased consistency in investor protections across financial services, we believe it makes sense to look at the protections provided in various channels and choose the best of each. 

We stand ready to work with Congress and the SEC in exploring whether a properly designed fiduciary standard could be applied to broker-dealers’ selling activities, 

and if there are problems raised, make a strong effort to resolve those problems. 

Conclusion 

It has become painfully clear that the current regulatory structure is weakened 

by gaps and inconsistencies that should be remedied. 

The individual investor is the most important player in the financial markets, and 

unfortunately, our system has not sufficiently protected these individuals. We need 

to earn back the confidence of those investors by closing the gaps in our current 

system and strengthening oversight. 

As I have stated, FINRA believes that one of the most important gaps to close 

in terms of investor protection is the disparity in oversight between broker-dealers 

and investment advisers. The addition of a comprehensive and regular oversight 

program with more frequent exams and strong enforcement would enhance protections provided to all customers of investment advisers. 

More broadly, investors deserve a consistent level of protection no matter which 

financial professionals or products they choose. Creating a system of consistent 

standards and vigorous oversight of financial professionals-no matter which license 

they hold-would enhance investor protection and help restore trust in our markets. 

FINRA is committed to working with other regulators and this Committee as you 

consider how best to restructure the U.S. financial regulatory system. 

PREPARED STATEMENT OF RONALD A. STACK 

CHAIR, 

MUNICIPAL SECURITIES RULEMAKING BOARD

MARCH 26, 2009 

Good morning Chairman Dodd, Ranking Member Shelby, and Members of the 

Committee. I am Ronald Stack, Chair of the Municipal Securities Rulemaking Board 

(‘‘MSRB’’ or ‘‘Board’’). I am pleased to testify today on behalf of the MSRB at the 

Committee’s second hearing on Enhancing Investor Protection and the Regulation 

of the Securities Markets. Part I of my testimony provides a summary of the 

MSRB’s structure, authority, rules, information systems, and market transparency/ 

surveillance activities. Part II provides background on the municipal securities market. Part III is a discussion of what the MSRB is doing now to promote transparency in the municipal marketplace. Part IV points out significant gaps in the 

regulation of municipal market participants and discusses the manner in which the 

MSRB could further assist in enhancing investor protection and the regulation of 

the securities market, if its jurisdiction were expanded by the Congress. Finally, 

Part V is an executive summary of our major recommendations. 

I. Background on the MSRB’s Structure, Authority, Rules, Information Systems, and Market Transparency/ Surveillance Activities 

A. MSRB Structure 

The MSRB is a self-regulatory organization (‘‘SRO’’) established by the Congress 

in the Securities Acts Amendments of 1975 to develop rules for brokers, dealers, and 

banks (collectively ‘‘dealers’’) engaged in underwriting, trading, and selling municipal securities. In furtherance of our investor protection mandate, the Board also operates information systems designed to promote transaction price transparency and 

access to municipal securities issuer disclosure documents. The MSRB stands as a 

unique SRO for a variety of reasons. The MSRB was the first SRO specifically established by Congress. Also unique is the fact that the legislation, codified in section 

15B of the Securities Exchange Act (‘‘Exchange Act’’), dictates that the MSRB Board 

shall be composed of members who are equally divided among public members (individuals not associated with any dealer), individuals who are associated with and 

representative of banks that deal in municipal securities (‘‘bank dealers’’), and indi-
167 

1 Under MSRB Rule A-3, the Board is composed of 15 member positions, with five positions 

each for public, bank dealer, and securities firm members. 2These fees are set forth in MSRB Rules A-12 through A-14. 

3These federal banking authorities consist of the Board of Governors of the Federal Reserve 

System, the Federal Deposit Insurance Corporation, and the U.S. Treasury Department through 

its Office of the Comptroller of the Currency and Office of Thrift Supervision, depending upon 

the specific bank dealer. 

viduals who are associated with and representative of securities firms. 1 At least one 

public member serving on the Board must represent investors and at least one must 

represent issuers of municipal securities. Further, the MSRB was created as a product-specific regulator, unlike most other securities regulatory bodies. Members of the 

MSRB meet throughout the year to make policy decisions, approve rulemaking, enhance information systems and review developments in the municipal securities 

market. Day-to-day operations of the MSRB are handled by a full-time independent, 

professional staff. The operations of the Board are funded through assessments 

made on dealers, including fees for underwritings and transactions. 2

B. MSRB Authority 

The substantive areas of the MSRB’s rulemaking authority are described in Section 15B(b)(2) of the Exchange Act, which lists several specific purposes to be accomplished by Board rulemaking with respect to the municipal securities activities of 

dealers in connection with their transactions in and provides a broad directive for 

rulemaking designed to: 

prevent fraudulent and manipulative acts and practices, to promote just 

and equitable principles of trade, to foster cooperation and coordination 

with persons engaged in regulating, clearing, settling and processing information with respect to and facilitating transactions in municipal securities, 

to remove impediments to and perfect the mechanism of a free and open 

market and, in general, to protect investors and the public interest. 

Like other SROs, the MSRB must file its proposed rule changes with the Securities and Exchange Commission (‘‘SEC’’) for approval prior to effectiveness. 

Although the MSRB was created to write rules that govern dealer conduct in the 

municipal securities market, the Exchange Act directs that inspection of dealers for 

compliance with, and the enforcement of, MSRB rules be carried out by other agencies. For securities firms, the Financial Industry Regulatory Authority (‘‘FINRA’’), 

along with the SEC, performs these functions. For bank dealers, the appropriate 

federal banking authorities, in coordination with the SEC, have this responsibility. 3

The MSRB works cooperatively with these regulators and maintains frequent communication to ensure that: (1) the MSRB’s rules and priorities are known to examining officials; (2) general trends and developments in the market discovered by field 

personnel are made known to the MSRB; and (3) any potential rule violations are 

immediately reported to the enforcement agencies. 

While Section 15B of the Exchange Act provides the MSRB with authority to 

write rules governing the activities of dealers in connection with their transactions 

in municipal securities, it does not provide the MSRB with authority to write rules 

governing the activities of other participants in the municipal finance market such 

as issuers and their agents (e.g., independent financial advisors, swap advisors, 

guaranteed investment contract brokers, trustees, bond counsel, etc.). Municipal securities also are exempt from the registration and prospectus delivery requirements 

of the Securities Act of 1933 and are exempt from the registration and reporting 

requirements of the Exchange Act. 

In adopting Section 15B of the Exchange Act, Congress provided in subsection (d) 

specific provisions that restrict the MSRB and the SEC from regulating the disclosure practices of issuers in certain ways. Paragraph (1) of subsection (d) prohibits 

the MSRB (and the SEC) from writing rules that directly or indirectly (i.e., through 

dealer regulation) impose a pre-sale filing requirement for issues of municipal securities. Paragraph (2) of subsection (d) prohibits the MSRB (but not the SEC) from 

adopting rules that directly or indirectly require issuers to produce documents or 

information for delivery to purchasers or to the MSRB. Paragraph (2), however, specifically allows the MSRB to adopt requirements relating to such disclosure documents or information as might be available from ‘‘a source other than such issuer.’’ 

The provisions of subsection (d) commonly are known as the ‘‘Tower Amendment.’’ 

C. MSRB Rules Overview 

The MSRB has adopted a substantial body of rules regulating dealer conduct that 

reflect the special characteristics of the municipal securities market and its unique 

regulatory needs These rules require dealers to observe the highest professional 
168 

4MSRB Notice 2008–04 on Bond Insurance Ratings (January 22, 2008). 

5MSRB Notice 2008–09 on Application of MSRB Rules to Transactions in Auction Rate Securities (February 19, 2008). 6MSRB Notice 2008–36 on Transactions Reporting of Dealer Buybacks of Auction Rate Securities: Rule G-14 (September 2, 2008). 7MSRB Notice 2008–34 on Bank Tying Arrangements, Underpricing of Credit and Rule G17 on Fair Dealing (August 14, 2008). 

standards in their activities and relationships with customers. MSRB rules take into 

account the fact that rules for dealers in the municipal market—where issuers have 

significant discretion and nondealer market professionals are unregulated—must 

sometimes be crafted in ways that differ from rules for dealers in the corporate securities market, where bond issuers and other market participants are subject to 

regulation. 

MSRB rules represent a balance between broad, ‘‘principles-based’’ rules and specific prescriptive rules, depending on the nature of the specific subject of regulation. 

MSRB rules can generally be categorized as (1) fair practice rules (e.g., requirements for dealers to provide affirmative disclosures of material facts to investors; 

to ensure the suitability of dealer recommendations of municipal securities transactions; to price transactions fairly; to avoid conflicts of interest; and to publish fair 

and accurate advertisements and price quotations); (2) uniform practice rules (e.g., 

rules to ensure that standard procedures are followed in underwriting, clearing, confirming, and settling transactions in municipal securities; helping to ensure the efficiency of market operations while accommodating the differences between municipal 

securities and other debt instruments); (3) professional qualification rules (e.g., requirements for dealer personnel to pass tests demonstrating competency; continuing 

education requirement); (4) operational standards (e.g., rules regarding recordkeeping; supervision of professionals); and (5) marketplace disclosure rules (e.g., 

rules requiring dealer real-time reporting of trade prices; underwriter filing of issuer 

disclosure documents; and dealer disclosure of political contributions to the MSRB 

for public dissemination). These rules significantly exceed the general antifraud 

principles that are embodied in the federal securities laws. 

Maintaining municipal market integrity is an exceptionally high priority for the 

MSRB as it seeks to foster a fair and efficient municipal securities market through 

dealer regulation. The MSRB engages in an on-going review of its rules and market 

practices to ensure that the Board’s overriding goal of protecting investors and 

maintaining market integrity is not compromised by emerging practices. As an example, the MSRB implemented rules to remove the conflict of interest that can arise 

when political contributions may be used by dealers to obtain municipal securities 

business. We also seek to coordinate our rules with FINRA rules in cases where 

similar requirements make sense. 

The MSRB also reminds dealers of its rules in times of market stress when the 

pace of events might cause some to lose sight of their significance. For example, during 2008, as bond insurer ratings were reduced frequently and significantly, we reminded dealers of their disclosure obligations concerning credit enhancement. 4 We 

also issued an interpretive notice on transactions in auction rate securities that reminded dealers of their obligation to recommend investments that are suitable to 

their customers 5 and provided guidance on reporting dealer buybacks of auction 

rate securities. 6 When many issuers rushed to convert their high yielding auction 

rate securities to variable rate demand obligations, we reminded dealers of restrictions on underpricing of credit and tying the provision of letters of credit to the provision of underwriting services. 7

D. Information Systems and Market Transparency/Surveillance 

In furtherance of our investor protection mandate, the MSRB also operates information systems to improve the availability of information in the market about municipal issues. These systems ensure that investors have information necessary to 

make investment decisions, that dealers can comply with MSRB rules, and that the 

inspection and enforcement agencies have the necessary tools to do their work. 

Since 1990, the Municipal Securities Information Library (‘‘MSIL’’) system has 

collected issuer primary market disclosure documents (i.e., official statements and 

advanced refunding documents) from underwriters and made them available to the 

market and the general public. The MSIL system also accepts and disseminates certain secondary market information provided by municipal issuers and trustees pursuant to SEC Rule 15c2-12. In order to further increase the accessibility of municipal market information by retail investors, the MSRB has developed a free, centralized database, named the Electronic Municipal Market Access system or EMMA, 

which is discussed further below and which will shortly replace the MSIL system. 
169 

8The MSRB’s transaction reporting rules require dealers to report transactions in municipal 

securities within 15 minutes of the time of trade execution. 9See The Bond Buyer/Thomson Financial 2004 Yearbook at 10. Approximately half of this figure represents short-term debt maturing in less than 13 months. 10Source: Thomson Reuters (based on 2005–2008 data). 11December 2008 estimates. See Federal Reserve Flow of Funds (March 2009) available at 

www.federalreserve.gov. As a comparison, the outstanding principal value of marketable U.S. 

Treasury Securities was $5.8 trillion. 12Over 99 percent of rated long-term municipal securities coming to market in 2008 were 

rated investment grade by at least one rating agency. 13Moody’s Rating Service, ‘‘Special Comment: Moody’s US Municipal Bond Rating Scale’’ (November 2002), available at http://www.moodys.com (also noting increased default risks for 

nonrated issues). 

In 2005, the MSRB implemented a facility for real-time transaction reporting and 

price dissemination of transactions in municipal securities (the ‘‘Real-Time Transaction Reporting System’’ or ‘‘RTRS’’). 8 RTRS serves the dual role of providing 

transaction price transparency to the marketplace, as well as supporting market 

surveillance by the enforcement agencies. Surveillance data is made available to 

regulators with authority to enforce MSRB rules, including FINRA and the SEC. 

The market surveillance function of the MSRB’s transaction reporting system provides enforcement agencies with a powerful tool in enforcing the Board’s fair pricing 

rules. The MSRB offers a market-wide real-time feed of trade information and provides the data free of charge on EMMA, as discussed below. In addition, in January 

of this year, the MSRB implemented an enhancement to the system with the addition of free public access to interest rate reset information on municipal auction-rate 

securities, including information on the success or failure of individual auctions. 

Free interest rate and related information on variable-rate demand obligations will 

be added to the system next week. And, beginning July 1 of this year, continuing 

disclosure filings made by state and local governments will be available as well. 

Once completed in July, 2009, the MSRB’s EMMA system will provide the most 

comprehensive and free database of municipal securities information as exists in 

any of the fixed income markets. 

Currently, EMMA does not contain information about the credit ratings of municipal securities, although they are of considerable importance to investors. The 

MSRB would welcome the submission by the rating agencies of such ratings on a 

real-time basis. Given the large number of bond insurer downgrades in the last 

year, investors should have access to underlying ratings as well as ratings on the 

municipal securities themselves. 

II. Background on the Municipal Securities Market 

A. Market Overview 

When Section 15B of the Exchange Act was adopted in 1975, yearly issuance of 

municipal securities was approximately $58 billion. 9 Much of this total represented 

general obligation debt, which reflected the simple, unconditional promise of a state 

or local government unit to pay to the investor a specific rate of interest for a specific period of time. The investors in these bonds tended to be commercial banks and 

property/casualty insurers interested in tax-exempt interest. 

The municipal securities market has grown into a much larger and more complex 

market. Annual issuance of municipal securities has averaged $458 billion in recent 

years 10 and a total of $2.7 trillion in principal value is outstanding. 11 In addition 

to providing capital for governmental projects and operations, the municipal securities market helps to fund a variety of other public purposes, including transportation and environmental infrastructure, education, housing and healthcare. 

Most municipal securities come to market with investment grade credit ratings, 

i.e., with ratings that are ‘‘BBB-’’ or above. 12 Historically, investment grade municipal securities have been considered relatively safe investments, because of the very 

low rate of default. A 2002 report by Moody’s Investor Service concluded that the 

default rate for investment grade municipal securities debt over a 10 year period 

was .03 percent, compared to 2.32 percent for investment grade corporate debt. 13

A low rate of default for investment grade municipal securities also has been observed in studies by Standard and Poor’s and Fitch Ratings. 

B. Issuers 

Issuers of municipal securities include towns, cities, counties, and states, as well 

as other state and local government agencies and authorities that issue securities 

for special purposes (e.g., hospitals and colleges). There are over 55,000 issuers of 

municipal securities that have outstanding approximately 1.23 million unique secu-
170 

14Source: Thomson Reuters (includes issuance of both long-term and short-term securities). 15Source: FINRA. Includes all TRACE-eligible securities. 16December 2008 estimates. See Federal Reserve Flow of Funds (March 2009), available at 

www.federalreserve.gov. Corporate debt outstanding excludes asset-backed securities and foreign 

issues held by U.S. residents. 

rities. Major issuer types, with the associated volume of issuance in 2008, are shown 

in Figure 1. 14

The market is unique among the world’s major capital markets because the number of issuers is so large—no other direct capital market encompasses so many borrowers. The issues range from multi-billion dollar financings of large state and city 

governments to issues less than $100,000 in size, issued by localities, school districts, fire districts, and various other issuing authorities. The purposes for which 

these securities are issued include not only financing for basic government functions, but also a variety of public needs such as transportation, utilities, health care, 

higher education, and housing as well as some essentially private functions to enhance industrial development. In the last two decades debt issuance has become an 

important management tool for many municipalities, allowing flexibility in arranging finances and meeting annual budget considerations according to local needs and 

local priorities. The terms and features of some municipal securities have evolved 

over time into highly complex structures to meet a multitude of issuer borrowing 

and investment needs. Differences in laws among the 50 states, as well in local ordinances and codes among the tens of thousands of localities, that affect borrowing 

authority, lending of credit, powers to impose taxes and special assessments, contracting powers, budgeting restrictions, and many other matters result in an enormous variety of financing structures across the country that defies commoditization 

of the municipal securities market. 

By contrast, there are only approximately 5,500 issuers of corporate debt and less 

than 50,000 corporate debt securities, 15 even though the amount of corporate debt 

outstanding is $6.3 trillion. 16

C. Investors 

The municipal securities market has one of the highest levels of participation by 

individual investors, either through direct investments or through mutual funds, together representing the majority of total municipal securities holdings. The other 

major categories of investors in municipal securities include property and casualty 

insurers and commercial banks. Figure 2 shows the percentages of direct investments in municipal securities in categories tracked by the Federal Reserve Board. 
171 

17Data collected by the Investment Company Institute (‘‘ICI’’) indicate that, as of September 

24, 2008, the total net assets in tax-exempt money market accounts were approximately $482 

billion, which would account for more than half of the Federal Reserve estimates of mutual fund 

holdings of municipal securities at this time. Of the $482 billion in tax-exempt money market 

funds tracked by the ICI in September, approximately $295 billion was held in retail money 

market funds and $187 billion was held in institutional money market funds. Source: ICI, 

‘‘Weekly Total Net Assets (TNA) and Number of Money Market Funds,’’ available at 

www.ici.org. 18Source: MSRB transaction data. 19The MSRB provides statistical data on market activity on its Web site at www.msrb.org 

and through EMMA. 

The ‘‘household’’ category in Figure 2 includes both direct investments by individual investors as well as trusts and other accounts (e.g., some types of hedge fund 

accounts that do not fall into other tracked categories). The ‘‘mutual funds’’ category 

includes both municipal bond funds and money market funds. 17

D. Municipal Securities Dealers 

The municipal securities market is an over-the-counter, dealer market. There are 

no central exchanges, specialists, or formal market maker designations. At the end 

of 2008, approximately 2,040 securities firms and banks were authorized to act as 

brokers and dealers in municipal securities (collectively, ‘‘dealers’’). During a given 

year, approximately 1,430 dealers report transactions in municipal securities to the 

MSRB under its price transparency program. About 185 of these dealers serve as 

managing underwriters of new issues. 

E. Market Activity 

In general, municipal securities investors tend to be ‘‘buy and hold’’ investors. 

Trading patterns for municipal securities with fixed interest rates typically involve 

relatively frequent trading during the initial weeks after issuance, followed by infrequent or sporadic trading activity during the remaining life of the security. Issues 

with variable interest rates tend to trade more frequently. Of the approximately 

1.23 million outstanding municipal securities, the likelihood of any specific security 

trading on a given day is about one percent. Less than 10 percent of outstanding 

municipal securities are likely to trade in any given month. 18

Notwithstanding the thin secondary market trading in individual municipal securities, aggregate daily trading activity in the market is substantial. During the period 2005–2008, an average of approximately 36,000 transactions in municipal securities was reported to the MSRB each business day, resulting in par values averaging about $23.2 billion per day. For the same period, nearly two-thirds of par 

value traded was variable rate securities, while fixed-rate securities accounted for 

almost 30 percent. Figure 3 shows the 30-day trailing average of daily transaction 

activity and volume in par (principal) amount traded for all types of municipal securities. 19
172 

III. MSRB Actions To Promote Transparency in the Municipal Market 

A. Primary Market Disclosure 

As noted above, since 1990, the MSRB has sought to improve the availability of 

municipal securities issuer disclosure documents to investors through its MSIL system. At that time, the SEC adopted its Rule 15c2-12 to, among other things, require 

the underwriter for most offerings of municipal securities to receive and review the 

issuer’s official statement before underwriting the issue. In turn, MSRB Rule G-36 

requires underwriters to submit such official statements to the MSIL system. The 

MSIL system was the first comprehensive library of primary market disclosure documents in the municipal securities market. The MSRB developed the MSIL system 

to serve as a repository of disclosure documents and a ‘‘wholesaler’’ of these documents to market participants and information vendors. Since most disclosure documents in 1990 were made available in paper form, the MSIL system received such 

documents, scanned them, and provided electronic versions to subscribers for a 

minimal fee for use in information products provided to the market. More recently, 

many primary market disclosure documents are available in electronic form and the 

MSRB receives such documents and provides them directly to subscribers. 

In March 2008, the MSRB launched its Electronic Municipal Market Access 

(‘‘EMMA’’) pilot. EMMA is an Internet-based disclosure portal that provides free 

public access to primary market disclosure documents and real-time municipal securities trade price data for the municipal securities market, in a manner specifically 

tailored to retail investors. The EMMA Web site is accessible at 

www.emma.msrb.org. EMMA currently provides an easily navigable integrated display of primary market disclosures and transaction pricing data for a specific security, incorporating detailed user help and investor education information designed 

to make the information easily understood by retail investors. EMMA currently provides free access to the MSRB’s full collection of issuer disclosure documents dating 

back to 1990, as well as to trade price information since January 2005. 

On Monday of this week, the MSRB filed with the SEC a proposal to continue 

operation of EMMA on a permanent basis and to provide for more rapid dissemination of primary market disclosures through a centralized electronic submission and 

public access service. The MSRB expects that this new phase of EMMA will be fully 

operational by the end of May of this year. At that time, all underwriters will be 

required to submit official statements and related documents and information to 

EMMA electronically for immediate free public access through the EMMA Web site 

portal. Users of the Web site will be able to sign up for free optional e-mail alerts 

to be notified of new and updated postings of disclosure documents and other information offered on EMMA. These documents will continue to be displayed in conjunction with real-time trade price information so that users viewing trading data for 

a specific municipal security will have immediate access to key disclosure information about that security. EMMA’s search engine is designed to assist retail investors 

in quickly finding the right document and information for a particular security. 

EMMA is the central force in moving the municipal securities market from the 

old paradigm where only the buyer of a specific new issue municipal security could 

be assured of receiving a copy of the disclosure document for that security when the 

trade is completed to a new marketplace where the general public will have free 

ongoing immediate access to disclosure documents for all issues as soon as the docu-
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20 July 26, 2007, available at http://www.sec.gov/news/press/2007/2007-148wp.pdf. 

ments become available. To further ensure broad access to the disclosures provided 

in official statements and advance refunding documents, the MSRB will make these 

documents available by subscription to information vendors and other bulk data 

users on terms that will promote the development of value-added services by subscribers for use by market participants. 

B. Continuing Disclosure 

The SEC revised its Rule 15c2-12 in 1995 to require underwriters to ensure that 

issuers have contracted to provide certain continuing disclosure information, including annual financial and operating data and material events notices, to certain private-sector information services designated as Nationally Recognized Municipal Securities Information Repositories (‘‘NRMSIRs’’). In these amendments, the MSRB 

was included as an alternative recipient of material event notices only. 

During the last few years, however, the MSRB grew concerned about investor access to continuing disclosure documents through the current NRMSIR system. As 

a result, after consultation with the SEC and review of the SEC’s White Paper to 

Congress on the municipal securities market, 20 the MSRB began to plan for a continuing disclosure component of EMMA. This enhancement will combine continuing 

disclosure information with the primary market disclosure and trade information 

currently available to provide a central location for all such municipal securities 

market information. 

On December 5, 2008, the SEC approved amendments to its Rule 15c2-12 to make 

the MSRB the central location for issuer continuing disclosure documents, effective 

July 1, 2009. EMMA’s continuing disclosure service will provide a user-friendly 

interface for free electronic submission of continuing disclosure documents by 

issuers, other obligated parties and their agents. As with official statements, these 

continuing disclosure documents will become immediately available for free to the 

general public through the EMMA Web site portal. Free optional e-mail alerts relating to new postings will also be made available in connection with continuing disclosure documents. In addition, the continuing disclosure documents will be integrated 

into the existing official statement and trade data display to produce an all-encompassing view of the relevant primary market, secondary market, and trade price information for each security in the marketplace easily accessible through EMMA’s 

powerful search engine. 

The MSRB expects to file with the SEC next week a proposed rule that would 

permit EMMA to accept voluntary filings of continuing disclosure by issuers and obligors. We hope that this will encourage disclosure beyond that which is currently 

required by SEC Rule 15c2-12, such as quarterly financial information and information about related municipal derivative transactions. 

C. Auction Rate Securities/Variable Rate Demand Obligation Transparency 

In 2009, the MSRB implemented its Short-term Rate Transparency (‘‘SHORT’’) 

System to increase transparency of municipal ARS and VRDOs. The SHORT System 

is the first centralized system for collection and dissemination of critical market information about ARS and VRDOs. Information collected by the SHORT System is 

made available to the public, free of charge, on EMMA. 

The SHORT System will be implemented in phases. The first phase, which became operational on January 30, 2009, collects and disseminates interest rate and 

related information about municipal ARS, including information about the success 

or failure of each auction. The SHORT System is scheduled to become operational 

for VRDOs on April 1, 2009. This interest rate information allows market participants to compare ARS and VRDOs across issues and track current interest rates. 

Included in this information is the current interest rate, the length of the interest 

rate reset period as well as characteristics of the security, such as the identities of 

broker-dealers associated with the operation of the securities. 

Later phases of this initiative to increase transparency of ARS and VRDOs include the collection and dissemination of ARS bidding information. This information 

will allow market participants to obtain important information about the liquidity 

of ARS and greater granularity into the results of the auction process. In addition, 

the MSRB plans to collect ARS documents that describe auction procedures and interest rate setting mechanisms as well as VRDO documents that describe the provisions of liquidity facilities, such as letters of credit and standby bond purchase 

agreements. 
174 

D. Market Statistics and Data 

EMMA provides market activity information, including transaction price data for 

the most recent daily trades and a daily summary of trading activity throughout the 

municipal securities market. EMMA’s daily trade summary provides the type of 

trade (i.e., customer bought, customer sold or inter-dealer trades), the number of securities and the number of trades for each trade type and the par amount of the 

trades for all published trades disseminated by the MSRB for every trading day 

since May 2006. This information is provided on EMMA’s market statistics pages 

and provides municipal securities investors with a market-wide view of the municipal securities market. An example of such information follows: 

Market statistics on EMMA also include the par amount traded for the most active sectors of the municipal securities market and trading volume by trade size, 

maturity, and source of repayment. 
175 

E. Investor Outreach and Education 

The MSRB is conducting an aggressive campaign to reach out to investors about 

all the information that is easily available to them through EMMA. We have also 

added important educational materials to the EMMA site to assist investors in their 

understanding of the municipal securities market. The MSRB is gratified that we 

have had over 53,000 visitors to EMMA in its 12 months of pilot operation who have 

downloaded almost 4.0 terabytes of files and data. Messages we have received 

through the EMMA feedback and contact pages indicate a very positive response 

from users, which include retail and institutional investors, brokers, investment advisors, issuers, information services, researchers, media, and others. We plan to continue diligently to improve EMMA’s service to both investors and issuers. 

The MSRB has long sought to improve investor access to municipal securities disclosure as well as to require, through its dealer regulation, that the municipal securities market continue to be fair to investors and efficient for all market participants. Once fully operational, EMMA will allow for more timely and accurate disclosures, valuations, and information regarding municipal securities, which will benefit 

all market participants. EMMA’s free public access to real-time trade price information and to the key disclosure documents has already provided unprecedented transparency to this market. As we complete each new phase of EMMA, the MSRB will 

provide increasing levels of transparency that will greatly benefit both investors and 

issuers alike and which is unparalleled in other markets. 

IV. An Expanded Role for the MSRB To Enhance Investor Protection and 

Regulation of the Securities Markets 

A. Unregulated Parties in the Municipal Securities Market. 

The current financial crisis has exposed gaps in the regulatory structure that governs U.S. financial institutions and the products they offer. It is clear that regulatory reform is necessary to address changes in the capital markets, such as the 

creation of new financial products and the emergence of firms providing advice regarding these products. The municipal securities marketplace has evolved from one 

in which states and municipalities offered traditional, fixed rate bonds to finance 

specific projects into a market that involves the use of complex derivative products 

and intricate investment strategies. 

Current federal law does not permit the MSRB to regulate the swap firms that 

assist in the creation of these derivative products for municipal issuers. The law 

also does not permit the MSRB to regulate other nondealer municipal market participants, such ‘‘independent’’ financial advisors that provide advice to issuers regarding bond offerings or investment brokers that assist issuers with investing bond 

proceeds. The MSRB believes regulation of these entities and other municipal advisors is essential to protect investors and ensure market integrity, and that the 

MSRB is in the best position to provide this regulation and therefore should be 

given such authority. The MSRB believes that its current regulatory structure for 

municipal securities dealers provides a ready model for oversight of municipal advisors, including financial advisors and investment brokers. The MSRB also believes 

that expanded oversight would be most effective in a dual regulatory structure with 

the SEC. Under this approach, firms would be required to register with the SEC, 

and the MSRB would provide more prescriptive rules applicable to these firms and 
176 

their activities. With the expansion of its jurisdiction, the MSRB’s composition 

should be reviewed to provide for appropriate representation of all types of regulated parties as well as to ensure expanded public representation. 

1. Financial Advisors and Investment Brokers and Other Municipal Market Participants. As federal lawmakers and policymakers are looking into unregulated participants throughout the financial markets such as mortgage brokers, so too should 

attention be paid to these participants in the municipal market. As municipal finance transactions have evolved and become more complex, there are many more 

advisors who work with municipal issuers, and brokers who act as intermediaries 

between issuers and others who provide necessary investment and other services. 

These participants have significant influence with issuers, earn significant fees, and 

many times, are not subject to any constraints on pay-to-play, as dealers have been 

since 1994. Unfortunately, the regulatory structure over the municipal market has 

not kept up with the evolving marketplace and nearly all of these participants are 

unregulated. At a minimum, municipal advisors such as financial advisors and investment brokers should be held to standards of conduct that protect municipal 

issuers, taxpayers, and investors in this market. The existing MSRB rulebook provides a ready model for the types of rules that could be developed for these market 

participants—particularly in light of the fiduciary nature of many of the advisory 

services they provide. Preventing pay-to-play throughout the municipal market is 

even more important now as the Congress has recognized the importance of rebuilding the Nation’s infrastructure and has supported that goal through the stimulus 

bill. Also, as Treasury seeks to find solutions to assist the municipal bond market 

through the financial crisis, ensuring that all market participants adhere to the 

highest professional standards is essential. 

Investors in the municipal securities market would be best served by subjecting 

unregulated market professionals to a comprehensive body of rules that (i) prohibit 

fraudulent and manipulative practices, (ii) require the fair treatment of investors, 

issuers, and other market participants, (iii) mandate full transparency, (iv) restrict 

real and perceived conflicts of interests, (v) ensure rigorous standards of professional 

qualifications, and(vi) promote market efficiencies. The municipal securities dealer 

community undertook the transition from being unregulated to becoming subject to 

such a body of rules and standards beginning in 1975 with the creation of the 

MSRB. The MSRB believes it is now time for the unregulated professionals in this 

market to undertake this same transition, and that the MSRB is the most appropriate regulatory body to provide this regulation. 

2. Current Regulation of Financial Advisors. It should be noted that many financial advisory firms are registered as broker-dealers or municipal securities dealers 

and are, therefore, subject to MSRB rules, including Rules G-23 and G-37. Rule G23 is a disclosure rule designed to minimize the apparent conflict of interest that 

exists when a municipal securities professional acts as both financial advisor and 

underwriter with respect to the same issue. With respect to financial advisors that 

are not dealers (known as ‘‘independent’’ financial advisors), approximately fifteen 

states have some form of pay-to-play prohibition. Some states have very broad payto-play rules that cover most state and local contracts, including those for financial 

advisory services. Other states have very narrow rules that apply only to specific 

situations. Some municipalities also have enacted such rules. Additionally, certain 

states and municipalities and agencies have disclosure obligations. While some 

states and localities have such pay-to-play laws, in many cases based on MSRB Rule 

G-37, the limited and patchwork nature of these state and local laws has not been 

effective in addressing in a comprehensive way the possibility and appearance of 

pay-to-play activities in the unregulated portions of the national municipal securities market. It is time for a coordinated and comprehensive approach to regulating 

municipal advisors, including ‘‘independent’’ financial advisors. 

3. Number of Financial Advisors Active in the Marketplace. Given the unregulated 

nature of this market, it is difficult to identify with precision the number of financial advisors, the number of offerings in which they participated, or the nature and 

scope of their advice. Nevertheless, the MSRB has reached out to market participants and has reviewed data on financial advisors supplied by Thomson Reuters. 

The MSRB believes that this information provides a reasonable estimate of the size 

of the market, but does not capture the entirety of it. 

Based on the MSRB’s review, of the 358 financial advisory firms that participated 

in at least one primary market transaction in 2008, only 98 were registered with 

the MSRB as dealers. It appears that the vast majority of active financial advisory 

firms currently are not regulated by the MSRB or, in general, anyone else. 
177 

4. Volume of Municipal Debt Issued With the Assistance of Financial Advisors. According to data obtained by the MSRB, approximately 70 percent of the total volume 

of municipal debt (by par amount) issued in 2008 was issued with the assistance 

of financial advisors. The total amount of municipal debt issued in 2008 was $453 

billion, and financial advisors provided advice in offerings that accounted for $315 

billion of this total. 

This percentage has increased over the last 2 years. In 2007, financial advisors 

participated in 66 percent of the total volume of offerings and, in 2006, financial 

advisors participated in 63 percent of the total volume of offerings. 
178 

The length of maturity of the offerings did not change the percentages significantly. In short-term offerings (maturities of less than 13 months) in 2008, financial 

advisors participated in 69.3 percent of the offerings, and in long term offerings, financial advisors participated in 69.7 percent of the offerings. Hence, an overwhelming percentage of short and long term offerings were issued with the assistance of financial advisors. 

5. Percentage of Unregistered Firms That Participated in Offerings. Dealers participated as financial advisors in 38 percent of the total volume of offerings in which 

financial advisors provided assistance. Correspondingly, unregistered financial advisors participated in 62 percent of those offerings, which represented $196 billion of 

the $315 billion total. 

6. The Role of Swap Advisors. The municipal securities derivatives market 

emerged in the 1980s and is still evolving. This market is very complex, with a variety of derivative products such as floating-to-fixed rate swaps, fixed-to-floating rate 

swaps, basis swaps, and swaptions. According to market participants, the vast majority of transactions are floating-to-fixed swaps, which are used to create synthetic 

fixed rate structures. These derivative products carry numerous embedded risks 

that may not be easily understood by less financially sophisticated issuers. Some 

such risks are interest rate risk, basis risk, tax risk, termination risk, and 

counterparty risk. Recent market conditions highlight this concern. Many sophisticated issuers face large swap termination fees due to changes in short-term interest 

rates. The extent to which many of these issuers may have underestimated the potential termination fees is of great concern to the MSRB. 

To assist issuers in understanding the characteristics, risks, and potential benefits of these products, many firms developed expertise as swap advisors. These 

firms, of which there are approximately four dozen, according to the Bond Buyer’s 

Municipal Marketplace Directory 2008, provide financial advice to issuers regarding 

swap policy development, transaction structuring, documentation, and pricing. Swap 

advisors now include boutique firms, registered broker-dealers, and banks. While 

many firms adhere to their own standards of professional conduct, their swap advisory services are, for the most part, unregulated. 

Also problematic is the lack of available public information regarding the size of 

the municipal securities derivative market. Market participants have suggested that 

the market is between $100 billion and $300 billion, annually, in notional principal 

amount, but until these derivative transactions are formally tracked, the figures will 

be unreliable. Given the complexity of municipal derivative transactions, the variety 

of risks, the growth of the market, and the reliance by issuers on the expertise of 

swap advisors, the MSRB believes these municipal market professionals should also 

be regulated. Moreover, the MSRB believes that its rules provide an appropriate 

framework for such regulation. 

7. The Role of Investment Brokers. A small group of advisory firms also provide 

investment advice to issuers concerning funds that are available to invest. These 

funds are typically bond funds, construction funds, escrow funds, debt service reserve funds, or capitalized interest funds. Advisory firms may recommend a variety 

of investments to the issuer, including bank investment agreements, guaranteed investment contracts, repurchase agreements, or forward delivery agreements. These 

investments may be offered by banks, insurance companies, or broker-dealers, and 

are bid competitively. Firms that offer such investment advice to issuers are not, 
179 

21See, e.g., U.S. Government Accountability Office, ‘‘Financial Regulation: A Framework for 

Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System 

(GAO-09-216),’’ January 8, 2009, available at http://www.gao.gov/new.items/d09216.pdf; Group 

of Thirty, ‘‘Financial Reform: A Framework for Financial Stability,’’ January 15, 2009, available 

at http://www.group30.org/pubs/publ1460.htm; U.S. Department of the Treasury, ‘‘Blueprint 

for a Modernized Financial Regulatory Structure,’’ available at http://www.treas.gov/press/releases/reports/Blueprint.pdf. 

for the most part, regulated. Given the complexity of these investments, their integral relationship to the municipal securities transactions, and the investment advice 

provided by these firms, MSRB believes that these municipal market professionals 

should be regulated as well. At a minimum, given the investment advice they provide to clients, these firms should be registered as investment advisors with the 

SEC. Additionally, MSRB believes that its rules, which go significantly beyond the 

antifraud provisions of the federal securities laws, provide an appropriate model for 

regulation of these market professionals. 

8. Municipal Issuers. When considering a new regulatory structure for the municipal securities market, it is important to recognize that the municipal market is distinct from other securities markets due to the role of sovereign municipal issuers, 

the diversity of issuer types, federal tax law and state law requirements and restrictions that relate to the issuance and sale of municipal securities. As the regulator 

of municipal securities dealers, the MSRB is keenly attuned to its role at the boundary between the federal government (establishing an efficient national marketplace 

and uniform investor protections) and states and municipalities exercising their 

public trust to meet the unique needs of their citizens. In the service of these goals, 

the MSRB has sought to provide rulemaking that is based on an understanding of 

the products that are being created and sold, and the dynamics driving decisions 

and market practices of the issuers, investors, and dealers. This requires careful tailoring of basic securities regulation principles to achieve key investor protection objectives without unduly imposing direct or indirect restraints on municipal issuers. 

The SEC ’s current jurisdiction includes authority to enforce antifraud laws with 

respect to issuers of municipal securities, and the SEC has brought enforcement actions in a number of high profile cases in the past few years. In addition, the associations representing state and local municipal issuers (Government Finance Officers Association and National Association of State Treasurers, in particular) also 

have an extensive body of recommended practices and an impressive educational 

outreach effort to help municipal issuers adhere to the highest standards of conduct. 

The MSRB is not suggesting the need for any additional federal regulation governing municipal issuers. 

We believe that the MSRB’s new EMMA system is a key turning point in moving 

forward with considerably improved disclosure practices in the municipal securities 

market, and the issuer community wholeheartedly supports this evolution. The current system of continuing disclosure based on a limited number of private enterprises, through which disclosures are available for a fee and in most cases only 

through a laborious process that does not promote public access, fails to provide the 

sunshine on disclosure practices that EMMA soon will. Good and bad disclosure 

practices alike are largely obscured in the current restrictive continuing disclosure 

scheme. This will no longer be the case with the advent of the MSRB’s continuing 

disclosure service through EMMA. The EMMA system will serve as a red flag for 

poor disclosure by issuers, while revealing good disclosure practices. It also will remove existing impediments to ensuring that investors buy and sell in securities 

based on the most up-to-date disclosures. The EMMA Web site will make it abundantly clear to investors when disclosures are less than satisfactory, as opposed to 

the current restrictive system. If investors are not satisfied with an issuer’s disclosure standards, or if they are alerted to information of concern through disclosures, 

they will extract a penalty, and the issuer eventually will pay the price through 

higher borrowing costs. In partnership with the state and local government issuer 

community, the MSRB believes that recent improvements in the quality and timeliness of disclosures in the municipal securities market will accelerate. 

B. Financial Markets Regulatory Structure 

The MSRB supports the concept of a multi-layered regulatory framework as a 

starting point for consideration of a new regulatory structure for the financial markets, as has been proposed by a number of governmental and nongovernmental bodies in recent months. 21

Such a multi-layered regulatory framework would consist of (1) a market stability 

regulator to address overall conditions of financial market stability that could impact the general economy; (2) a prudential financial regulator; and (3) a business 

conduct regulator (linked to consumer protection regulation) to address standards 
180 

for business practices. The MSRB stands ready to work closely with any systemic 

regulator to gather and analyze data about the municipal market as it relates to 

systemic risk in the financial markets. As well as a repository for municipal market 

data, the MSRB can be even better equipped to proactively monitor market activity 

and assist aggressively in enforcement activities. 

A multi-layered regulatory approach, or in fact any scenario, requires that the 

regulatory entities have deep and extensive knowledge of all financial markets. The 

lack of municipal finance expertise at the federal level became apparent during the 

past year and resulted in a very late and limited recognition of the impact of the 

credit crisis on state and local municipal finances, and the failure of federal programs intended to alleviate the economic impact of the credit crisis to address the 

needs of state and local governments. 

To this end, the MSRB strongly recommends the creation of a Treasury Department office or other significant federal position charged with representing the 

unique needs of the municipal securities market. We have proposed to President 

Obama’s Administration, as an alternative to such a federal position, the development of a senior level group to coordinate municipal finance issues among the White 

House, Department of the Treasury, Federal Reserve, SEC, MSRB, and other federal agencies and stakeholders. 

C. Self-Regulatory Organizations 

The MSRB also believes that there is an important role for market-specific, selfregulatory organizations in any comprehensive regulatory framework. These SROs 

would continue to adopt rules and standards, establish market mechanisms and systems and standards of operations, and adopt market-specific rules and standards for 

investor protection. These SRO activities can far exceed the antifraud standards of 

the federal securities laws and can extend to the regulation of the behavior of market intermediaries, thereby ensuring the goals of investor protection and integrity 

of the securities markets. SROs are also uniquely situated to work with the industry 

to develop effective rules and information systems, and can be vital links between 

the industry and the broader regulatory community. SRO jurisdiction must be flexible and broad enough to encompass new products, market developments, new market entrants, market movements, and other changes. 

D. Enforcement 

Enforcement is key to an effective system of municipal regulation. Traditionally, 

enforcement activities have been spread across numerous federal and state governmental entities and self-regulatory organizations, consisting of the SEC, FINRA, 

various bank regulatory agencies, and state attorneys general, creating a patchwork 

of overlapping jurisdiction and inconsistent and uncoordinated enforcement activities. The SEC can be more effective if given additional resources for municipal enforcement. Further, while some coordination of enforcement activities currently exists, the MSRB strongly recommends that each of the entities that are charged with 

the enforcement of securities laws—regardless of the genesis of those laws—develop 

a more formal process to coordinate their regulatory and enforcement activities. Coordinated actions could avoid regulatory gaps, provide clearer statutory authority 

and promote an efficient and consistent enforcement mechanism for the industry. 

Finally, we recommend that Congress modify the MSRB’s regulatory authority to 

include an enforcement and examination support function that would further 

strengthen enforcement in the municipal securities market. With an increased statutory mandate, the MSRB could better analyze the large amount of data that we 

collect to assist in surveillance of the market. The MSRB and its staff have a depth 

of expertise in all aspects of the municipal market that is found nowhere else in 

the federal government, and we stand ready to further assist, if given the congressional mandate. 

E. Derivative Products 

While derivatives can be an important risk management tool, they can be dangerous if the state and local government issuers who purchase them do not understand the risks they may create. The current state of the law as articulated in the 

Commodities Futures Modernization Act of 2000 prohibits regulation of swap agreements (which are broadly defined) with the exception of antifraud, and the issue of 

whether and how to regulate credit default swaps (‘‘CDS’’) and other derivative instruments remains controversial. While municipal derivatives play an important 

risk management role in the overall municipal securities market, municipal derivatives are only a fraction of the overall derivatives markets. The MSRB recognizes 

that the question of whether to regulate municipal derivative instruments should 

be answered by Congress in the context of the broader derivatives market and that, 
181 

should Congress choose to place such derivative products under new regulations, the 

regulatory structure should encompass municipal derivatives as well. 

In particular, consideration should be given to the inclusion of municipal CDS in 

the types of CDS covered by central counterparties and clearinghouses. The application of central counterparties and clearinghouses to municipal CDS would address 

concerns about the problems of lack of minimum capitalization of CDS protection 

sellers. It would also address the lack of transparency in CDS pricing, which currently may disadvantage certain investors and dealers. Furthermore, it would provide municipal issuers with information about whether dealers who underwrite 

their securities are also selling CDS on their debt. Issuers who considered such a 

dual role to pose a conflict of interest could then take whatever actions they deemed 

appropriate. Should enhanced disclosures in derivative instruments be a part of any 

regulatory scheme, the MSRB is well poised with its EMMA system to provide disclosures of municipal derivative contracts and provide the necessary transparency 

for our market. 

V. Executive Summary 

Since its creation in 1975, the MSRB has worked diligently to foster and preserve 

a fair and efficient municipal securities market that serves the public interest. The 

dual goals of investor protection and market integrity have guided this mission. 

However, the increased sophistication of our market, changing financial markets 

generally, and the importance of investor protection in the market require a review 

of the regulatory structure of this market. 

To that end, we make the following recommendations: 

• We believe that financial advisors, investment brokers, and other intermediaries in the municipal market should be brought under a comprehensive 

regulatory scheme. Further, we believe that the MSRB is the appropriate regulatory body to regulate these unregulated municipal market participants, as 

part of a dual regulatory structure with the SEC. 

• We support a multi-layered overall regulatory framework for the financial markets consisting of a market stability regulator, a prudential financial regulator, 

and a business conduct regulator. 

• We believe that there is an important role for market-specific SROs that are 

charged with adopting rules and standards, market mechanisms, information 

systems, and standards of operations that embody and expand upon the basic 

antifraud standards of the federal securities laws. 

• We recommend the creation of a Treasury Department office or other significant 

federal position charged with representing the unique needs of the municipal 

securities market, or alternatively, a senior-level multiple-agency group to coordinate municipal finance issues among all market stakeholders. 

• We strongly recommend that federal and state entities charged with the enforcement of securities laws develop a more formal process to coordinate their 

regulatory and enforcement activities. 

• We believe that derivative instruments based on municipal securities should be 

subject to the same comprehensive regulatory framework that may be developed 

for swaps and other types of derivative financial products in other markets. The 

rules governing dealer activity developed by the MSRB over its history provide 

an appropriate model for the comprehensive regulation that should apply to all 

financial intermediaries active in the municipal market. 

We stand ready to assist in this important work and are certain that investor protection will be served by increasing our mandate. 

PREPARED STATEMENT OF RICHARD BAKER 

PRESIDENT AND CHIEF EXECUTIVE OFFICER, 

MANAGED FUNDS ASSOCIATION

MARCH 26, 2009 

Managed Funds Association (‘‘MFA’’) is pleased to provide this statement in connection with the Senate Committee on Banking, Housing, & Urban Affairs hearing, 

‘‘Enhancing Investor Protection and the Regulation of Securities Markets—Part II’’ 

held on March 26, 2009. MFA represents the majority of the world’s largest hedge 

funds and is the primary advocate for sound business practices and industry growth 

for professionals in hedge funds, funds of funds and managed futures funds, as well 
182 

as industry service providers. MFA’s members manage a substantial portion of the 

approximately $1.5 trillion invested in absolute return strategies around the world. 

MFA appreciates the opportunity to express its views on the important subjects 

of investor protection and the regulation of securities markets. In considering theses 

issues, it is important to remember that vibrant, liquid markets are important to 

investors and that for these markets to work, financial institutions need to be able 

to perform their important market functions. 

Hedge funds play an important role in our financial system, as they provide liquidity and price discovery to capital markets, capital to companies to allow them 

to grow or turn around their businesses, and sophisticated risk management to investors such as pension funds, to allow those pensions to meet their future obligations to plan beneficiaries. Hedge funds engage in a variety of investment strategies 

across many different asset classes. The growth and diversification of hedge funds 

have strengthened U.S. capital markets and allowed investors means to diversify 

their investments, thereby reducing their overall portfolio investment risk. As investors, hedge funds help dampen market volatility by providing liquidity and pricing 

efficiency across many markets. Each of these functions is critical to the orderly operation of our capital markets and our financial system as a whole. 

In order to perform these important market functions, hedge funds require sound 

counterparties with which to trade and stable market structures in which to operate. The recent turmoil in our markets has significantly limited the ability of hedge 

funds to conduct their businesses and trade in the stable environment we all seek. 

As such, hedge funds have an aligned interest with other market participants, including retail investors, and policy makers in reestablishing a sound financial system. We support efforts to protect investors, manage systemic risk responsibly, and 

ensure stable counterparties and properly functioning, orderly markets. 

Hedge funds were not the root cause of the problems in our financial markets and 

economy. In fact, hedge funds overall were substantially less leveraged than banks 

and brokers, performed significantly better than the overall market and have not 

required, nor sought, federal assistance despite the fact that our industry, and our 

investors, have suffered mightily as a result of the instability in our financial system and the broader economic downturn. The losses suffered by hedge funds and 

their investors did not pose a threat to our capital markets or the financial system. 

Although hedge funds are important to capital markets and the financial system, 

the relative size and scope of the hedge fund industry in the context of the wider 

financial system helps explain why hedge funds did not pose systemic risks despite 

their losses. With an estimated $1.5 trillion under management, the hedge fund industry is significantly smaller than the U.S. mutual fund industry, with an estimated $9.4 trillion in assets under management, or the U.S. banking industry, with 

an estimated $13.8 trillion in assets. According to a report released by the Financial 

Research Corp., the combined assets under management of the three largest mutual 

fund families are in excess of $1.9 trillion. Moreover, because many hedge funds use 

little or no leverage, their losses did not pose the same systemic risk concerns that 

losses at more highly leveraged institutions, such as brokers and investment banks, 

did. A study by PerTrac Financial Solutions released in December 2008 found that 

26.9 percent of hedge fund managers reported using no leverage. Similarly, a March 

2009 report by Lord Adair Turner, Chairman of the U.K. Financial Services Authority (the ‘‘FSA’’), found that the leverage of hedge funds was, on average, two or 

three-to-one, significantly below the average leverage of banks. 

Though hedge funds did not cause the problems in our markets, we believe that 

the public and private sectors (including hedge funds) share the responsibility of restoring stability to our markets, strengthening financial institutions, and ultimately, 

restoring investor confidence. Hedge funds remain a significant source of private 

capital and can continue to play an important role in restoring liquidity and stability to our capital markets. The value of hedge funds (and other private pools of 

capital) as private investors has been recognized by Treasury Secretary Geithner in 

his proposals for the recently announced Public Private Partnership Investment Program (the ‘‘PPIP’’) and implementation of the Term Asset-Backed Securities Loan 

Facility, each of which is dependent on private investor participation to be successful. In addition to providing liquidity, managers of private pools of capital have significant trading and investing experience and knowledge that can assist policy makers as they continue to contemplate the best way to implement the Administration’s 

Financial Stability Plan. 

MFA is supportive of the new PPIP. We share Secretary Geithner’s commitment 

to promote efforts that will stabilize our financial markets and strengthen our Nation’s economy. MFA and its members look forward to working with Secretary 

Geithner, Congressional leaders, and members of President Obama’s economic team 
183 

on this and other important issues in order to achieve the shared objective of restoring stability and investor confidence in our financial markets. 

Regulatory reform also will be an important part of stabilizing markets and restoring investor confidence, but it will not, in and of itself, be sufficient to do so. 

The lack of certainty regarding major financial institutions (e.g., banks, broker dealers, insurance companies) and their financial condition has limited the effectiveness 

of government intervention efforts to date. Investors’ lack of confidence in the financial health of these institutions is an impediment to those investors’ willingness to 

put capital at risk in the market or to engage in transactions with these firms, 

which, in turn, are impediments to market stability. The Treasury Department’s 

plan to conduct comprehensive stress tests on the 19 largest bank holding companies is designed to ensure a robust analysis of these banks, thereby creating greater 

certainty regarding their financial condition. Treasury’s announcement that it plans 

to involve private asset managers in helping to value illiquid assets held by banks 

as part of the PPIP recognizes the beneficial role that private asset managers can 

play in helping provide that certainty. We believe that, to achieve this certainty, it 

is also important for policy makers and regulators to ensure that accounting and 

disclosure rules are designed to promote the appropriate valuation of assets and liabilities and consistent disclosure of those valuations. 

Though ‘‘smart’’ regulation cannot, in and of itself, restore financial stability and 

properly functioning markets, it is a necessary component of any plan to achieve 

those ends. ‘‘Smart’’ regulation would include appropriate, effective, and efficient 

regulation and industry best practices that better monitor and reduce systemic risk 

and promote efficient capital markets, market integrity, and investor protection. 

Regulation that addresses these key issues is more likely to improve the functioning 

of our financial system, while regulation that does not address these key issues can 

cause more harm than good. We saw an example of the latter with the significant, 

adverse consequences that resulted from the SEC’s bans on short selling last year. 

A smart regulatory framework should include comprehensive and robust industry 

best practices designed to achieve the shared goals of monitoring and reducing systemic risk and promoting efficient capital markets, market integrity, and investor 

protection. Since 2000, MFA has been the leader in developing, enhancing and promoting standards of excellence through its document, Sound Practices for Hedge 

Fund Managers (‘‘Sound Practices’’). As part of its commitment to ensuring that 

Sound Practices remains at the forefront of setting standards of excellence for the 

industry, MFA has updated and revised Sound Practices to incorporate the recommendations from the best practices report issued by the President’s Working 

Group on Financial Markets’ Asset Managers’ Committee. 

Because of the complexity of our financial system, an ongoing dialogue between 

market participants and policy makers is a critical part of the process of developing 

smart, effective regulation. MFA and its members are committed to being active, 

constructive participants in the dialogue regarding the various regulatory reform 

topics. 

I. Systemic Risk Regulation 

The first step in developing a systemic risk regulatory regime is to determine 

those entities that should be within the scope of such a regulatory regime. There 

are a number of factors that policy makers are considering as they seek to establish 

the process by which a systemic risk regulator should identify, at any point in time, 

which entities should be considered to be of systemic relevance. Those factors include the amount of assets of an entity, the concentration of its activities, and an 

entity’s interconnectivity to other market participants. 

As an Association, we are currently engaged in an active dialogue with our members to better understand how these factors, among others, may relate to the systemic relevance of all financial market participants—including our industry and its 

members. MFA and its members acknowledge that at a minimum the hedge fund 

industry as a whole is of systemic relevance and, therefore, should be considered 

within the systemic risk regulatory framework. We are committed to being constructive participants in the dialogue regarding the creation of that framework. 

A. Central Systemic Risk Regulator 

Under our current regulatory structure, systemic risk oversight is the responsibility of multiple regulatory entities, or worse, no one’s responsibility. For systemic 

risk oversight to be effective, there must be oversight over the key elements of the 

entire financial system, across all relevant structures, classes of institutions and 

products, and an assessment of the financial system on a holistic basis. We believe 

that a single central systemic risk regulator should be considered to accomplish this 

goal. This central regulator should be responsible for oversight of the structure, 
184 

classes of institutions and products of all financial system participants. MFA is engaged in discussions with its members with respect to which regulatory entity, 

whether new or existing, would be best suited for this role. 

We believe that having multiple regulators with responsibility for overseeing systemic risk likely would not be an effective framework. Jurisdictional conflicts, unintended gaps in regulatory authority, and inefficient and costly overlapping authorities likely would inhibit the effectiveness of such a regulatory framework. Moreover, 

in a framework with multiple systemic risk regulators, no one regulator would be 

able to assess potential systemic risks from a holistic perspective, as no regulator 

would oversee the entire system. 

B. Confidential Reporting to Regulator 

MFA and its members recognize that for a systemic risk regulator to be able to 

adequately assess potential risks to our financial system, that regulator needs access to information. We support a systemic risk regulator having the authority to 

request and receive, on a confidential basis, from those entities that it determines 

(at any point in time) to be of systemic relevance, any information that the regulator 

determines is necessary or advisable to enable it to adequately assess potential risks 

to the financial system. 

In considering the appropriate scope of this authority, we believe that it is important for the systemic risk regulator to have sufficient authority and flexibility to 

adapt to changing conditions and take a forward-looking view toward risk regulation. Attempting to pre-determine what information a regulator would need would 

not provide sufficient flexibility and likely would be ineffective as a tool to address 

potential future risks. We believe that granting the systemic risk regulator broad 

authority with respect to information gathering, along with ensuring that it has the 

appropriate resources and capabilities to effectively analyze that information, would 

be a more effective framework. 

While we support a systemic risk regulator having access to whatever information 

it deems necessary or advisable to assess potential systemic risks, we believe that 

it is critical for such information to be kept confidentially and granted full protection from public disclosure. We recognize the benefit of a regulator having access 

to all important data, even potentially sensitive or proprietary information from systemically relevant entities. A systemic risk regulator can fulfill its mandate to protect the financial system without publicly disclosing all the proprietary information 

of financial institutions. We do not believe that there is a public benefit to such information being publicly disclosed. 

Moreover, public disclosure of such information could be misleading, as it would 

likely be incomplete data that would be viewed by the public outside of the proper 

context. Public investors may be inclined to take action based on this data without 

fully understanding the information, which could lead to adverse consequences for 

those investors, for the investors in systemically relevant entities, and for the stability of the financial system as a whole. Public disclosure of proprietary information 

also harms the ability of market participants to establish and exit from investment 

positions in an economically viable manner. Such disclosure also could lead to systemically relevant entities being placed at an unfair competitive disadvantage compared to nonsystemically relevant entities, as sensitive and proprietary information 

of only the systemically relevant entities would be publicly available. 

C. Mandate To Protect the Financial System 

Setting a clear and specific mandate is important for any regulator to be effective. 

This is particularly true in a regulatory framework that has multiple regulatory entities, as a lack of clarity in the mandates of regulators can lead to gaps in oversight, or costly and inefficient overlapping regulation. We believe that the systemic 

risk regulator’s mandate should be the protection of the financial system. Investor 

protection and market integrity should not be part of its mandate, but should instead be addressed by other regulatory entities. Congress should be clear in stating 

that the risk regulator should collect information only for its mandate to protect the 

financial system, and should not use that authority for other purposes. 

To fulfill its mandate to protect the financial system, we recognize that the regulator would need to take action if the failure of a systemically relevant firm would 

jeopardize broad aspects of the financial system. Absent such a concern about broad 

systemic consequences, however, the systemic risk regulator should not focus on preventing the failure of systemically relevant entities. Systemically relevant market 

participants do not necessarily pose the same risks or concerns as each other. There 

likely are entities that would be deemed systemically relevant for purposes of reporting information, but whose failure would not threaten the broader financial system. For this reason, we believe that the systemic risk regulator should focus on 
185 

preventing failures of market participants only when there is concern about the consequences to the broader financial system, and should not focus on preventing the 

failure of all systemically relevant entities. 

Consistent with this mandate, the systemic risk regulator should not equate systemically relevant entities with entities that are too big, or too interconnected, to 

fail. An entity that is perceived by the market to have a government guarantee, 

whether explicit or implicit, has an unfair competitive advantage over other market 

participants. We strongly believe that the systemic risk regulator should implement 

its authority in a way that avoids this possibility and also avoids the moral hazards 

that can result from a company having an ongoing government guarantee against 

its failure. 

D. Scope of Regulatory Authority 

The last part of systemic risk regulation that I would like to address in my testimony is the scope of authority that a systemic risk regulator should have to fulfill 

its mandate to protect our financial system. There are a number of suggestions that 

various people have made as to the type of authority a systemic risk regulator 

should have. We continue to discuss with our members what the appropriate scope 

of authority should be for such a regulator. 

We believe that whatever authority the regulator has should ensure that the regulator has the ability to be forward-looking to prevent potential systemic risk problems, as well as the authority to address systemic problems once they have arisen. 

The systemic risk regulator’s authority must be sufficiently flexible to permit it to 

adapt to changing circumstances and address currently unknown issues. An attempt 

to specifically define the regulator’s authority must avoid unintentionally creating 

gaps in authority that would prevent the systemic risk regulator from being able 

to fulfill its mandate to protect the financial system in the future. 

We do believe that the systemic risk regulator needs the authority to ensure that 

a failing market participant does not pose a risk to the entire financial system. In 

the event that a failing market participant could pose such a risk, the systemic risk 

regulator should have the authority to directly intervene to ensure an orderly dissolution or liquidation of the market participant. The significant adverse consequences that resulted from the failure of Lehman Brothers, Inc. this past fall is 

an example of what can happen when there is not an intervention to prevent a disorderly dissolution of such a market participant. The continuing market disruption 

caused by the failure of Lehman Brothers also demonstrates the importance of ensuring that there is a coordinated global effort with respect to such interventions. 

Whatever the scope of authority that a systemic risk regulator has, its implementation of that authority will be critical to the effectiveness of any regulatory regime. 

We believe that the systemic risk regulator should implement its authority by focusing on all relevant parts of the financial system, including structure, classes of institutions and products. Because systemic risk concerns may arise from a combination 

of factors, rather than from the presence of any particular factor, a holistic approach 

is more likely to successfully identify and assess potential systemic risks. 

Recent coordinated efforts between the Federal Reserve Bank of New York (the 

‘‘New York Fed’’) and industry participants provide a good example of how a systemic risk regulator could address systemic risk concerns posed by structural issues 

in our markets. In recent years, the New York Fed, working with MFA and other 

industry participants through the Operations Management Group (‘‘OMG’’) and 

other industry-led initiatives has made notable progress in addressing concerns related to the over-the-counter (‘‘OTC’’) derivatives market. Some of the more recent 

market improvements and systemic risk mitigants have included: (1) the reduction 

by 80 percent of backlogs of outstanding credit default swap (‘‘CDS’’) confirmations 

since 2005; (2) the establishment of electronic processes to approve and confirm CDS 

novations; (3) the establishment of a trade information repository to document and 

record confirmed CDS trades; (4) the establishment of a successful auction-based 

mechanism actively employed in 14 credit events including Fannie Mae, Freddie 

Mac and Lehman Brothers, allowing for cash settlement; and (5) the reduction of 

74 percent of backlogs of outstanding equity derivative confirmations since 2006 and 

53 percent of backlogs in interest rate derivative confirmations since 2006. 

In addition to these efforts, MFA, its members and other industry participants 

have been working with the New York Fed to expedite the establishment of central 

clearing platforms covering a broad range of OTC derivative instruments. We believe a central clearing platform, if properly established, could provide a number of 

market benefits, including: (1) the mitigation of systemic risk; (2) the mitigation of 

counterparty risk and protection of customer collateral; (3) market transparency and 

operational efficiency; (4) greater liquidity; and (5) clear processes for the determination of a credit event (for CDS). 
186 

1Statement of Securities and Exchange Commission Concerning Short Selling and Issuer 

Stock Repurchases, SEC Release 2008-235 (Oct. 1, 2008). 2Temporary Short Selling Measures, FSA Consultation Paper 09/1 (Jan. 2009), at page 4. 

II. Prudential Regulation 

We recognize that, in addition to systemic risk regulation, some policy makers, 

regulators and authors of various reports (e.g., the Group of 30, Government Accountability Office and Congressional Oversight Panel) have contemplated the notion of a prudential regulatory framework, including mandatory registration for private pools of capital. There are a great many issues that should be considered in 

determining what, if any, such a framework should look like. As an Association, we 

are currently engaged in an active dialogue with our members on these critical 

issues and we are committed to being constructive participants as discussions on 

these issues progress. 

While many of the details regarding reform initiatives have yet to be proposed, 

we would like to share some initial thoughts with you on some of the key principles 

that we believe should be considered by Congress, the Administration and other policy makers as you consider prudential regulatory reform. Those principles are: 

• The goal of regulatory reform should be to develop intelligent regulation, which 

makes our system stronger for the benefit of businesses and investors. 

• Prudential regulation should address identified risks or potential risks, and 

should be appropriately tailored to those risks. 

• Regulators should engage in ongoing dialogue with market participants. Any 

rulemaking should be transparent and provide for public notice and comment 

by affected market participants, as well as a reasonable period of time to implement any new or modified regulatory requirements. This public–private dialogue can help lead to more effective regulation and avoid unintended consequences, market uncertainty and increased market volatility. 

• Reporting requirements should provide regulators with the right information to 

allow them to fulfill their oversight responsibilities as well as to prevent, detect 

and punish fraud and manipulative conduct. Overly broad reporting requirements can limit the effectiveness of a reporting regime as regulators may be unable to effectively review and analyze data, while duplicative reporting requirements can be costly to market participants without providing additional benefit 

to regulators. I would add that it is critical that any reporting of sensitive, proprietary information by market participants be kept confidential. As discussed 

in the section above on reporting to a systemic risk regulator, public disclosure 

of such information can be harmful to members of the public that may act on 

incomplete data, increase risk to the financial system, and harm the ability of 

market participants to establish and exit from investment positions in an economically viable manner. 

• We believe that any prudential regulatory construct should distinguish, as appropriate, between different types of market participants and different types of 

investors or customers to whom services or products are marketed. While we 

recognize that investor protection should not be limited only to retail investors, 

we believe that a ‘‘one-size fits all’’ approach will likely not be as effective as 

a more tailored approach. 

• Lastly, we believe that industry best practices and robust investor diligence 

should be encouraged and viewed as an important complement to prudential 

regulation. Strong business practices and robust diligence are critical to addressing investor protection concerns. 

III. Short Selling 

One issue in particular which has been the focus of a great deal of discussion recently is short selling, specifically the role of short selling in capital markets. Short 

selling, as recognized by the Securities and Exchange Commission (the ‘‘SEC’’), 

‘‘plays an important role in the market for a variety of reasons, including providing 

more efficient price discovery, mitigating market bubbles, increasing market liquidity, facilitating hedging and other risk management activities and, importantly, limiting upward market manipulations.’’ 1 Similarly, the FSA has noted that short selling is, ‘‘a legitimate investment technique in normal market conditions,’’ and ‘‘can 

enhance the efficiency of the price formation process by allowing investors with negative information, who do not hold stock, to trade on their information.’’ In addition, 

short selling can ‘‘enhance liquidity by increasing the number of potential sellers,’’ 

and increase market efficiency. 2 We strongly agree with the SEC and the FSA that 

short selling, along with derivatives trading, provides capital markets with nec-
187 

1Prior to founding Kynikos Associates LP, I was a securities analyst at Deutsche Bank Capital and Gilford Securities. My first job on Wall Street was as an analyst at the investment 

banking firm of Blyth Eastman Paine Webber, a position I took in 1980 upon graduating from 

Yale University with a B.A. in Economics and Political Science. 

essary liquidity and plays an important role in the price discovery process. Markets 

are more efficient, and securities prices are more accurate, because investors with 

capital at risk engage in short selling. 

Short selling and other techniques, including listed and over-the-counter derivatives trading, are important risk management tools for institutional investors, including MFA members, and essential components of a wide range of bona fide cash 

and derivatives hedging strategies that enable investors to provide liquidity to the 

financial markets. 

We are concerned that requirements that investors publicly disclose short position 

information, or that create the potential for public disclosure, would negatively reduce overall market efficiency by undermining the important role that short selling 

plays in providing liquidity and price discovery to markets. The risk of public disclosure could cause investors, including pension plans and endowments, with billions 

of dollars of assets to withdraw capital and further disrupt already stressed capital 

markets. In the long-term, pension, endowment and foundation investors would 

forego diversification and risk management benefits provided by alternative investment vehicles. 

We believe that concerns which have led some to propose public disclosure of 

short positions could be substantially mitigated through effective, comprehensive reporting of short sale information by prime brokers and clearing brokers. Regulators 

could require short sales and short position information to be provided by brokers 

on an aggregate basis. A regulator could request specific information as to short 

sales and short positions of individual investors if it suspected or became concerned 

about manipulation of a particular security. Such reporting also would provide regulators with a more effective means by which to identify manipulative activity. 

Conclusion 

Hedge funds have important market functions, in that they provide liquidity and 

price discovery to capital markets, capital to companies to allow them to grow or 

turn around their businesses, and sophisticated risk management to investors such 

as pension funds, to allow those pensions to meet their future obligations to plan 

beneficiaries. MFA and its members acknowledge that smart regulation helps to ensure stable and orderly markets, which are necessary for hedge funds to conduct 

their businesses. We also acknowledge that active, constructive dialogue between 

policy makers and market participants is an important part of the process to develop smart regulation. We are committed to being constructive participants in the 

regulatory reform discussions and working with policy makers to reestablish a 

sound financial system and restore stable and orderly markets. 

MFA appreciates the opportunity to testify before the Committee. I would be 

happy to answer any questions that you may have. 

PREPARED STATEMENT OF JAMES CHANOS 

CHAIRMAN, 

COALITION OF PRIVATE INVESTMENT COMPANIES

MARCH 26, 2009 

Chairman Dodd, Ranking Member Shelby, and Members of the Committee. My 

name is James Chanos, and I am President of Kynikos Associates LP, a New York 

private investment management company that I founded in 1985. 1 I am appearing 

today on behalf of the Coalition of Private Investment Companies (CPIC), a group 

of about twenty private investment companies with a wide range of clients that include pension funds, asset managers, foundations, other institutional investors, and 

qualified wealthy individuals. 

I want to thank the Senators of this Committee for your efforts to develop and 

implement an approach to modernize financial regulation which would address the 

failures and inadequacies that contributed to the financial crisis confronting our 

country and our global economy. I am honored to have this opportunity to testify 

on behalf of CPIC and look forward to working with you and your staff in the 

months ahead. 
188 

I. Executive Summary 

This is a difficult time for our Nation. Overhauling our regulatory structure is 

necessary to regain investor confidence. Honesty and fair dealing are at the foundation of the investor confidence our markets enjoyed for so many years. A sustainable 

economic recovery will not occur until investors can again feel certain that their interests come first and foremost with the companies, asset managers, and others 

with whom they invest their money, and until they believe that regulators are effectively safeguarding them against fraud. 

In recent years, prior to the current economic downturn, many observers of the 

financial system believed that hedge funds and other private pools of capital would 

be the source of the next financial crisis. Of course, as we have all painfully learned, 

in fact, the greatest danger to world economies came not from those entities subject 

to indirect regulation, such as hedge funds, but from institutions such as banks, insurance companies, broker-dealers, and government-sponsored enterprises operating 

with charters and licenses granted by state and federal regulators and under direct 

regulatory supervision, examination, and enforcement. Indeed, Bernard Madoff used 

his firm, Bernard L. Madoff Investment Securities, LLC—which was registered with 

the SEC as a broker-dealer and investment adviser and subject to examination and 

regulation—to perpetrate his Ponzi scheme. 

Nonetheless, hedge funds and other private investment companies are important 

market players, and we recognize that a modernized financial regulatory system— 

one that addresses overall risk to the financial system and that regulates market 

participants performing the same functions in a consistent manner—will include 

regulation of hedge funds and other private pools of capital. We are ready to work 

with you as you seek to craft appropriate regulation for our industry. 

With respect to the new regime for monitoring systemic risk, CPIC would like to 

offer the following principles upon which to base legislative and regulatory action: 

• First, regulation must be based upon activities, not actors, and it should be 

scaled to size and complexity. 

• Second, all companies that perform systemically significant functions should be 

regulated. 

• Third, regulators should have the authority to follow the activities of systemically important entities regardless of where in the entity that activity takes 

place. 

• Fourth, as complexity of corporate structures and financial products intensifies, 

so, too should regulatory scrutiny. 

• Fifth, there should be greater scrutiny based upon the ‘‘Triple Play’’—being an 

originator, underwriter/securitizer and investor in the same asset. 

• Sixth, and above all, the systemic risk regulator must enforce transparency and 

practice it. 

With respect to increasing the functional regulation of hedge funds, CPIC offers 

the following for your consideration: 

• Simply removing exemptions from the Investment Company Act and the Investment Advisers Act upon which private investment funds rely will prove unsatisfactory. 

• Any new regulation should provide for targeted controls and safeguards to provide appropriate oversight of private investment companies, but should also preserve the flexibility of their operations. 

• More detailed requirements for large private investment companies would address the greater potential for systemic risk posed by such funds, depending on 

their use of leverage and their trading strategies. 

• Regulation should address basic common-sense protections for investors in private investment companies, particularly with respect to disclosure, custody of 

fund assets, and periodic audits. 

• Areas such as counterparty risk, lender risk, and systemic risk should be addressed through disclosures to regulators and counterparties. 

With respect to hedge funds as significant investors in the capital markets, CPIC 

believes that maximum attention should be paid to maintaining and increasing the 

transparency and accuracy of financial reporting to shareholders, counterparties, 

and the market as a whole. 
189 

2Testimony of James Chanos, Chairman, Coalition of Private Investment Companies. U.S. 

Senate Committee on Banking, Housing, and Urban Affairs Subcommittee on Securities and Investment. Hearing on the Hedge Fund Industry. May 16, 2006. Available at: http://banking.senate.gov/public/lfiles/ACF82BA.pdf. 3Kambhu, John, Schuermann, Til and Stiroh, Kevin J., Hedge Funds, Financial Intermediation, and Systemic Risk. Economic Policy Review, Vol. 13, No. 3, December 2007 (available at 

SSRN: http://ssrn.com/abstract=1012348). 4Knowledge@Wharton, ‘‘Hedge Funds Are Growing: Is This Good or Bad?’’ June 29, 2005. 

Available at: http://knowledge.wharton.upenn.edu/article.cfm?articleid=1225&CFID=4349082&CFTOKEN=6202640. Jeremy Siegel, Professor of Finance at the Wharton School of the University of Pennsylvania, observes that short selling contributes to the market’s process of finding correct prices, and it’s valuable to have hedge funds 

doing this. Sebastian Mallaby, ‘‘Hands Off Hedge Funds,’’ Foreign Affairs, January/February 

2007. Available at: http://www.foreignaffairs.org/20070101faessay86107/sebastian-mallaby/ 

hands-off-hedge-funds.html. The importance of hedge funds has been acknowledged by the President’s Working Group on Financial Markets, the Commodities Futures Trading Commission, the 

Securities and Exchange Commission, two chairs of the Federal Reserve Board, and members 

of Congress. 5 Hedge Fund Research, Inc. ‘‘Investors Withdraw Record Capital from Hedge Funds as Industry Concludes Worst Performance Year in History.’’ Press Release. Available at: https:// 

www.hedgefundresearch.com/pdf/prl01212009.pdf. 6Written Testimony of Andrew W. Lo, Hedge Funds, Systemic Risk, and the Financial Crisis 

of 2007–2008, Prepared for the U.S. House of Representatives Committee on Oversight and Government Reform November 13, 2008 Hearing on Hedge Funds. 7Mr. Geithner stated: ‘‘Hedge funds play a valuable arbitrage role in reducing or eliminating 

mispricing in financial markets. They are an important source of liquidity, both in periods of 

calm and stress. They add depth and breadth to our capital markets. By taking risks that would 

otherwise have remained on the balance sheets of other financial institutions, they provide an 

importance source of risk transfer and diversification.’’ Available at: http://www.ny.frb.org/ 

newsevents/speeches/2004/gei041117.html. Mr. Geithner also stated ‘‘Hedge funds, private equity funds and other kinds of investment vehicles help to disperse risk and add liquidity.’’ See 

Keynote Address at the National Conference on the Securities Industry: Hedge Funds and Their 

Implications for the Financial System (November 17, 2004). Remarks at the Institute of International Bankers Luncheon in New York City (October 18,2005). Available at: http:// 

www.ny.frb.org/newsevents/speeches/2005/gei051018.html. 8 McKinsey Global Institute, Mapping Global Capital Markets: Fifth Annual Report. October 

2008. Available at: http://www.mckinsey.com/mgi/reports/pdfs/fifthlannuallreport/ 

fifthlannuallreport.pdf. 

II. The State of the Hedge Fund Sector 

Since I last testified before the Senate Banking Committee on May 16, 2006, 2 the 

hedge fund industry has undergone profound change in the face of unprecedented 

challenges. In 2006, the industry was continuing its rapid growth and evolution into 

new strategies and products, to offer qualified investors greater flexibility and opportunities for managing risks and achieving returns that exceeded equity and bond 

markets’ performance. In 2006, the industry had an estimated $1.47 trillion in assets under management and there were an estimated 9,462 funds. A year later, 

total assets under management for an estimated 10,096 funds rose to about $1.87 

trillion, culminating 18 years of growth since 1990 at a cumulated average annual 

growth rate (CAGR) of 25 percent. In several markets, hedge funds became the 

main players, accounting for more than 50 percent of trading in U.S. convertible 

bonds, distressed debt, and credit derivatives. 3 We experienced a host of new strategies to address investors’ increasingly complex risk-management and asset growth 

demands, as the variety and complexity of financial instruments—and the global nature of those products—grew exponentially. The sheer variety of investment strategies that hedge funds employed strengthened capital markets, improved opportunities for price discovery, and facilitated the efficient allocation of capital. 4

The attraction of hedge funds was a function, too, of their performance. According 

to Hedge Fund Research, Inc., hedge funds have returned an average of 11.8 percent 

annually during the period 1990 through 2008, and an average 15.9 percent in the 

12 months following the five largest historical declines. 5

As Andrew W. Lo, a professor at the MIT Sloan School of Management, testified 

on November 13, 2008, ‘‘[t]he increased risk-sharing capacity and liquidity provided 

by hedge funds over the last decade has contributed significantly to the growth and 

prosperity that the global economy has enjoyed.’’ 6 It is a point that Treasury Secretary Timothy F. Geithner made as Federal Reserve Bank President and CEO in 

speeches in 2004 and 2005. 7

Despite the rapid growth and size of hedge funds ($1.41 trillion), their relative 

size with the financial sector is small, accounting for 0.7 percent of the $196 trillion 

invested in equities, tradable government and private debt, and bank deposits, according to McKinsey Global Institute. 8
190 

9There are many research papers and studies that examine the source of the financial crisis. 

One example: Gary B. Gorton, ‘‘The Panic of 2007.’’ August 25, 2008. Yale ICF Working Paper 

No. 08-24. Available at: http://ssrn.com/abstract=1255362. 10 I would encourage you to read the trenchant analysis by Lord Adair Turner, Chairman of 

the U.K. Financial Services Authority (‘‘FSA’’), in which he eloquently recounts how developments in the banking and the near-bank system caused serious harm to the real economy. Lord 

Adair Turner, Chairman, FSA. ‘‘The financial crisis and the future of regulation.’’ January 21, 

2009. The Economist’s Inaugural City Lecture (available at http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2009/0121lat.shtml. A more extensive discussion is provided 

in: The Turner Review: A Regulatory Response to the Global Banking Crisis. March 18, 2009 

(available at http://www.fsa.gov.uk/pages/Library/Communication/PR/2009/037.shtml). 11 According to Hedge Fund Research, Inc. ‘‘during 2008, the industry experienced a period 

of six consecutive months of declines between June and November, interrupted only by December’s 0.41 percent gain, including a concentrated, volatile two-month period in September and 

October in which the cumulative decline approached 13 percent.’’ See supra n. 5. 

In the summer of 2007 and throughout 2008, financial markets began to unravel. 

Major regulated financial institutions collapsed or went bankrupt as the U.S. Treasury administered life support through both capital infusions and U.S.-backed guarantees to prevent the demise of banks, insurance companies, and others who were 

deemed ‘‘too big to fail,’’ and thereby stave off an imminent global economic collapse 

comparable to that of the Great Depression. A chain of interlinked securities—including derivatives and off-balance sheet vehicles—sensitive to housing prices triggered a death spiral in financial markets worldwide, demonstrating the scale and 

intensity of interdependence in the global economy and the vulnerability it causes. 9

As the problems became more severe, the crisis mushroomed beyond subprime debt 

to threaten less risky assets. Credit markets dried up, and equity markets in 2008 

posted one of their worst years since the 1930s. As a result, the value of financial 

assets held at banks, investment firms, and others collapsed, jeopardizing their survival as they sharply curtailed activities. Institutional investors rushed to the sidelines, seeking safe havens in cash investments. The downturn spread throughout 

our economy and worldwide, fueling job losses, prompting bankruptcies, and causing 

household wealth to erode. That is a greatly distilled and simplified recounting of 

the events in 2007–2009. And, as might be expected with those events, the hedge 

fund industry experienced a sharp reversal. 10

As a consequence of the financial crisis, as was the case with other sectors of the 

financial services industry, the amount of money managed by hedge funds plummeted, reflecting an amalgam of sharp declines in asset values, the rise in client 

redemptions, and regulatory closures of margin accounts. Last year was easily 

among the worst in the industry’s history, with total assets under management falling to $1.41 trillion—a decline of $525 billion from the all-time peak of $1.93 trillion 

reached mid-year 2008, with more than 1,471 funds—a record in 1 year—liquidating. Investors withdrew a record $155 billion. 

Hedge funds on average in 2008 posted their worst performance since 1990. The 

HFRI Fund Weighted Composite Index dropped 18.3 percent for all of last year, 

which was only the second calendar year decline since 1990. 11 That said, though, 

hedge fund losses on average were less than those of the S&P500, with 24 different 

hedge fund strategies performing better than the S&P 500 benchmark. 

III. Mitigation of Systemic Risk 

The financial crisis of the past 2 years has raised many questions about the extent to which systemic risks are effectively contained and ameliorated within the 

U.S. and global economies. As globalization has led to better risk sharing and increased market liquidity, shocks originating in one market are more quickly transmitted to other markets. Regulators and central banks say they need more information to understand the sources of risks and potential impact on markets and economies. Consensus is emerging among U.S. policy makers and in other countries for 

the need to strengthen systemic risk regulation. Towards that end, allow me to outline some basic principles to guide the thinking about establishing a regulator with 

responsibility for addressing systemic risks and the attendant laws and regulations 

to accomplish that objective. 

First, regulation must be based upon activities, not actors, and it should be scaled 

to size and complexity. Regulatory scrutiny should be triggered based upon any of 

the following: the overall scale of market participants, relative importance in a given 

market or markets, complexity of corporate structure, and complexity of financial 

instruments used for investment or dealer purposes. All participants undertaking a 

similar activity should be treated equally; for example, proprietary trading by financial institutions should not be treated in a different manner than trading by any 

other kind of entity. While the regulator should have broad and flexible authority 

to determine the basis upon which it wants to include systemically significant enti-
191 

12 United States Department of the Treasury, Fact Sheet: Public–Private Investment Program 

(Mar. 23, 2009) (available at http://www.treas.gov/press/releases/reports/ 

ppiplfactlsheet.pdf). 

ties, it should be clear and transparent in disclosing the criteria upon which it seeks 

to include a specific market participant. 

Second, all companies that perform systemically significant functions should be 

regulated. The regulator should have the authority to examine and discipline market players such as credit rating agencies and financial guarantors, based on the 

importance of the integrity of their functions to the entire financial system. 

Third, the regulator should have the authority to follow the activities of systemically important entities regardless of where in the entity that activity takes place. 

No matter where the activity takes place in a corporation, regulators should be allowed to look into those activities. This point speaks against assigning regulators 

specific discrete parts of entities to cover and for an evolution of functional regulation. 

Fourth, as complexity of corporate structures and financial products intensifies, 

so, too should regulatory scrutiny. Greater regulatory scrutiny should be borne by 

complex enterprises—not just in the sense of adding additional functional regulation 

for each new piece of a diversified company but also in the sense of materially increasing the federal regulatory oversight exercised by any new systemic regulator. 

Entities should come under the ambit of a systemic regulator based upon the complexity, opacity, and system-wide interdependent nature of the instruments that 

they underwrite, produce, deal in or invest. 

Fifth, there should be greater scrutiny based upon the ‘‘Triple Play’’—being an 

originator, underwriter/securitizer, investor in the same asset. Greater regulatory 

scrutiny should be borne by those entities that endeavor to achieve the trifecta: that 

is, to own the ‘‘means of production’’ of an asset, to act as a dealer in financial instruments created from those assets, and to be a direct investor in those instruments or assets. In other words, if a company were a mortgage originator, a dealer 

in mortgage-backed securities, and an investor for its own account in mortgagebacked securities, that ‘‘triple play’’ would trigger oversight by the systemic regulator not only of the individual activities but also the management of the inherent 

conflicts of interest between those vertically integrated pieces. 

Sixth, and above all, a systemic risk regulator must enforce transparency and 

practice it. The regulatory structure should include reviews of how accurately entities make required disclosures of their true financial condition to their shareholders 

and/or counterparties and investors. The regulator, too, must be transparent; it 

should annually disclose the entities under its regulatory umbrella and the reason 

for their inclusion. The regulator should be accountable to Congress and the public. 

Although the markets alone are not up to the task of identifying and containing systemic risk, it is also the case that the government alone is not up to the task. The 

combined efforts of government regulators and market discipline brought about by 

transparent disclosure of risks are needed in any plan for future operation of our 

financial markets. Further, consideration should be given to modeling disclosure of 

regulatory or enforcement activity on those of the SEC or CFTC, rather than some 

of the other, more opaque, federal regulatory agencies. 

IV. Hedge Funds and Functional Regulation 

Private investment companies of all types play significant, diverse roles in the financial markets and in the economy as a whole. Venture capital funds, for instance, 

are an important source of funding for start-up companies or turnaround ventures. 

Other private equity funds provide growth capital to established small-sized companies, while still others pursue ‘‘buyout’’ strategies by investing in underperforming 

companies and providing them with capital and/or making organizational changes 

to improve results. These types of funds may focus on providing capital in the energy, real estate, and infrastructure sectors. Hedge funds trade stocks, bonds, futures, commodities, currencies, and a myriad of other financial instruments on a 

global level. These flexibly structured pools of capital provide substantial benefits 

to their investors and to the markets more broadly in terms of liquidity, efficiency, 

and price discovery. In addition, they are a potential source of private investment 

to participate with the government in addressing the current financial crisis. 12 It, 

therefore, is in all of our interests that private investment funds continue to participate in our financial markets. 
192 

13See Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) (15 U.S.C. §78j) 

and Rule 10b-5 thereunder (17 C.F.R. § 240.10b-5). 14 12 C.F.R. §§220, 221, 224. 15See, e.g., Exchange Act §§13(d), 13(e), 14(d), 14(e) and 14(f) (15 U.S.C. §§78m(d), 78m(e), 

78n(d), 78n(e) and §78n(f)) and related rules (which regulate and require public reporting on 

the acquisition of blocks of securities and other activities in connection with takeovers and proxy 

contests). 16Section 3(c)(1) of the Investment Company Act excludes a company from the definition of 

an ‘‘investment company’’ if it has 100 or fewer beneficial owners of its securities and does not 

offer its securities to the public. Under the Securities Act of 1933 and SEC rules, an offering 

is not ‘‘public’’ if it is not made through any general solicitation or advertising to retail investors, 

but is made only to certain high-net-worth individuals and institutions known as ‘‘accredited investors.’’ ‘‘Accredited investors’’ include banks, broker-dealers, and insurance companies. The 

term also includes natural persons whose individual net worth or joint net worth with a spouse 

exceeds $1 million, and natural persons whose individual income in each of the past 2 years 

exceeds $200,0000, or whose joint income with a spouse in each of the past 3 years exceeds 

$300,000, and who reasonably expect to reach the same income level in the current year. 

Section 3(c)(7) of the Investment Company Act excludes a company from the definition of an 

‘‘investment company’’ if all of its securities are owned by persons who are ‘‘qualified purchasers’’ at the time of acquisition and if the Company does not offer its securities to the public. 

Congress added this section to the Investment Company Act in 1996 after determining that 

there should be no limit on the number of investors in a private investment fund, provided that 

all of such investors are ‘‘qualified purchasers.’’ In brief, ‘‘qualified purchasers’’ must have even 

greater financial assets than accredited investors. Generally, individuals that own not less than 

$5 million in investments and entities that own not less than $25 million in investments are 

qualified purchasers. 

Section 203(b)(3) of the Advisers Act exempts from registration any investment adviser that, 

during the course of the preceding twelve months has had fewer than fifteen clients and that 

does not hold itself out as an investment adviser nor act as an investment adviser to any investment company. Advisers to hedge funds and other private investment companies are generally 

excepted from registration under the Advisers Act by relying upon Section 203(b)(3), because 

a fund counts as one client. 

In some cases, where these companies and their advisers engage in trading commodity futures, they also comply with exemptions from registration under the ‘‘commodity pool operator’’ 

and ‘‘commodity trading advisor’’ provisions of the Commodity Exchange Act (‘‘CEA’’). These exemptions generally parallel the exemptions from registration under the securities laws. 17 In my testimony before the SEC’s public roundtable on hedge funds in 2003, I recommended that, as a further condition to exemption under the Advisers Act, hedge funds should 

be subject to specific standards relating to investor qualifications, custody of fund assets (an 

issue on which there now is significant focus as a result of the Madoff scandal), annual audits 

and quarterly unaudited reports to investors, clear disclosure of financial arrangements with interested parties (such as the investment manager, custodian, prime broker, and others—in order 

to address conflicts issues), clear disclosure of investment allocation policies, and objective and 

transparent standards for valuation of fund assets that are clearly disclosed, not stale, and subject to audit. Statement of James Chanos, President, Kynikos Associates, SEC Roundtable on 

Hedge Funds (May 15, 2003) (available at http://sec.gov/spotlight/hedgefunds/hedgechanos.htm). 

When I testified before this Committee in 2004, I expanded upon these points and recommended that the SEC require, as a condition to a hedge fund’s exemption under the Advisers 

Act, that hedge funds file basic information with the SEC and certify that they met the standards outlined above. Testimony before the Senate Committee on Banking, Housing and Urban 

Affairs, Hearing on Regulation of the Hedge Fund Industry (Jul. 15, 2004) (available at http:// 

banking.senate.gov/public/index.cfm?FuseAction=Hearings.Hearing&HearinglID=79b80b77- 

While it often is said that private investment companies are ‘‘unregulated,’’ they 

are, in fact, subject to a range of securities antifraud, antimanipulation, 13 margin, 14

and other trading laws and regulations that apply to other securities market participants. 15 They also are subject to SEC enforcement investigations and subpoenas, 

as well as civil enforcement action and criminal prosecution if they violate the federal securities laws. However, private investment companies and their advisers are 

not required to register with the SEC if they comply with the conditions of certain 

exemptions from registration under the Investment Company Act of 1940 (the ‘‘Investment Company Act’’) and the Investment Advisers Act of 1940 (‘‘Advisers 

Act’’). 16 Congress created exemptions under these laws because it determined that 

highly restrictive requirements of laws designed to regulate publicly offered mutual 

funds and investment advisers to retail investors were not appropriate for funds designed primarily for institutions and wealthy investors. 

To date, legislative proposals to regulate private investment companies have been 

directed at removing the exemptions from regulation of private investment companies under the Investment Company Act and Advisers Act and thus subjecting private investment companies to the requirements of those Acts. But, for policy makers 

who believe private investment companies and their managers should be subject to 

greater federal oversight, I would argue that simply eliminating the exemptions in 

either or both of these statutes will prove unsatisfactory. 17
193 

9855-47d4-a514-840725ad912c). See also Letter from James Chanos to Jonathan Katz, SEC 

(Sept. 15, 2004) (available at http://www.sec.gov/rules/proposed/s73004/s73004-52.pdf). This 

would have provided the SEC with hedge fund ‘‘census’’ data it has long said it needs; it also 

would have provided a basis for SEC enforcement action against any fund failing to meet the 

above standards. Had the SEC adopted this recommendation, the agency would have avoided 

the legal challenge to the rule it adopted later that year to change its interpretation of the term 

‘‘client’’ under the Advisers Act in order to require hedge fund managers to register. See Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). 

As this Committee knows, the SEC’s hedge fund adviser registration rule was struck down 

in 2006, (id.) and the SEC decided not to appeal. Some hedge fund managers that had registered 

with the SEC under the rule withdrew their registrations. I decided that my firm should remain 

registered as an investment adviser (which we are still today), but, as I testified in 2006 before 

this Committee, the Advisers Act is ‘‘an awkward statute for providing the SEC with the information it seeks . . . and for dealing with the broader issues that are outside the Act’s purposes.’’ 

Testimony of James Chanos, CPIC, before the Senate Committee on Banking, Housing and 

Urban Affairs, Subcommittee on Securities and Investment; Hearing on the Hedge Fund Industry, at 7 (available at http://banking.senate.gov/public/—files/ACF82BA.pdf). 18For example, convertible bond arbitrage relies on selling short the underlying equity security while buying the bond. This strategy provides an essential support for the convertible bond 

market, upon which many corporations rely for capital. 

The first lesson we all learned in shop class is you need to use the right tool for 

the job. Although you can use a pipe wrench to pound in a nail, or a claw hammer 

to loosen up a pipe, it is not a good idea to do so. Neither the Investment Company 

Act nor the Advisers Act is the right tool for the job of regulating hedge funds and 

other private investment companies. They do not contain the provisions needed to 

address the potential risks posed by the largest large private investment companies, 

the types of investments they hold, and the contracts into which they enter. At the 

same time, those laws each contain provisions designed for the types of businesses 

they are intended to regulate—laws that would either be irrelevant to oversight of 

private investment companies or would unduly restrict their operation. If Congress 

determines that legislation is needed, I believe a more tailored and targeted law 

should be drafted in order to address current public policy concerns about investor 

protection and systemic risks. Yet, Congress should avoid trying to shoehorn private 

investment companies into laws designed for retail investors. 

For example, the Investment Company Act and Advisers Act are designed purely 

for investor protection, and have no provisions designed to protect counterparties or 

to control systemic risk. Similarly, these acts are generally silent on methods for 

winding down an investment fund or client account, an area which the law should 

address in some detail for large private investment companies. Further, the Advisers Act custody provisions exclude certain types of instruments that are commonly 

owned by private investment funds, an exclusion that would deprive investors in 

those funds of the protection that a custody requirement provides. 

At the same time, many requirements of the Investment Company Act and the 

Advisers Act are irrelevant, or would be counterproductive, if applied to private investment companies. For example, current restrictions on mutual funds from engaging in certain types of transactions, such as trading on margin and short selling, 

would severely inhibit or foreclose a number of hedge fund trading strategies that 

are fundamental to their businesses and the markets. 18 As another example, requirements for boards of directors imposed by the Investment Company Act and 

compensation restrictions imposed by the Advisers Act are not particularly well 

suited to the regulation of managers of investment pools with high net worth and 

institutional investors. Such investors are fully capable of understanding the implications of performance-based fees, and do not need regulatory attention to protect 

themselves. Likewise, client-trading restrictions under the Advisers Act that require 

client consent on a transaction-by-transaction basis are unduly burdensome for private fund management. In sum, the Investment Company Act and Advisers Act, 

which were adopted in largely their current forms in 1940, are not well suited to 

being adapted for a new use in regulating investment structures and strategies developed primarily over the last 20 years. 

Congress should think carefully as it considers the right tool for the task of regulating private investment companies. In my view, whatever legislation is developed 

should contain targeted controls and safeguards needed to provide appropriate oversight for the regulation of such entities, yet retain the flexibility of their operations. 

Congress may wish to consider more detailed requirements on large private investment companies (or families of private investment companies) in order to address 

the greater potential for systemic risk posed by such funds, depending upon their 

use of leverage and their trading strategies. 

Congress also may wish to consider giving legal effect to certain measures that 

were identified as ‘‘best practices’’ for fund managers in a report issued earlier this 
194 

19 Report of the Asset Managers’ Committee: Best Practices for the Hedge Fund Industry 

(January 15, 2009) (available at http://www.amaicmte.org/Asset.aspx). 20 In brief, under FAS 157, Level 1 assets are those that have independently derived and observable market prices. Level 2 assets have prices that are derived from those of Level 1 assets. 

Level 3 assets are the most difficult to price—theirs are derived in part by reference to other 

sources and rely on management estimates. Disclosure of profits and losses from these categories will allow investors to better assess the diversification and risk profile of a given investment, and to determine the extent to which fund valuations are based on the ‘‘best guess’’ of 

fund management. 21David Reilly, Elvis Lives and Mark to Market Rules Fuel Crisis (Mar. 11, 2009), Bloomberg 

(available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aD11FOjLK1y4). ‘‘Of 

the $8.46 trillion in assets held by the 12 largest banks in the KBW Bank Index, only 29 percent 

is marked to market prices, according to my analysis of company data. General Electric Co., 

meanwhile, said last week that just 2 percent of assets were marked to market at its General 

Electric Capital Corp. subsidiary, which is similar in size to the sixth-biggest U.S. bank. What 

are all those other assets that aren’t marked to market prices? Mostly loans—to homeowners, 

businesses and consumers. Loans are held at their original cost, minus a reserve that banks 

create for potential future losses. Their value doesn’t fall in lockstep with drops in market 

year by the Asset Managers’ Committee (‘‘AMC Best Practices’’)—a group on which 

I served at the request of the President’s Working Group on Financial Markets. 19

For example, one of the most important of these recommendations is that managers 

should disclose more details—going beyond Generally Accepted Accounting Standards—regarding the portion of income and losses that the fund derives from Financial Accounting Standard (FAS) 157 Level 1, 2, and 3 assets. 20 Another recommendation is that a fund’s annual financial statements should be audited by an 

independent public accounting firm that is subject to PCAOB oversight. Still another recommendation would assure that potential investors are provided with specified disclosures relating to the fund and its management before any investment is 

accepted. This type of information should include any disciplinary history and pending or concluded litigation or enforcement actions, fees and expense structure, the 

use of commissions to pay broker-dealers for research (‘‘soft dollars’’), the fund’s 

methodology for valuation of assets and liabilities, any side-letters and side-arrangements, conflicts of interest and material financial arrangements with interested parties (including investment managers, custodians, portfolio brokers, and placement 

agents), and policies as to investment and trade allocations. 

Congress also should require safeguards that I have advocated for many years— 

simple, common-sense protections relating to custody of fund assets and periodic audits. 

As I mentioned earlier, there are areas of importance to the financial system that 

the Investment Company Act and Advisers Act do not address, including 

counterparty risk, lender risk, and systemic risk. These types of issues can be addressed through required disclosures to regulators and to counterparties. Of course, 

Congress also will need to choose a regulator, and since the SEC already has regulatory responsibility over publicly-offered funds, the SEC is the logical choice. If 

Congress decides to establish an overall systemic risk regulator, that regulator also 

may have a role in overseeing the largest, systemically important funds. 

V. Hedge Funds as Financial Investors 

One of the most important roles that hedge funds play in our economy is that of 

investor. Perhaps no other role played by hedge funds and other private investment 

vehicles, like venture capital funds, is more important to a return to economic 

growth than this one. From the point of view of an investor that provides capital 

to corporations by buying equity or debt, or of a potential purchaser of asset-backed 

securities in the secondary market, certain principles will be essential to encouraging investment in products that do not carry an explicit government and taxpayer 

guarantee against loss. One key principle is a generally accepted and respected 

valuation of assets. 

Mark-to-market (‘‘MTM’’) accounting is not perfect, but it does provide a compass 

for investors to figure out what an asset would be worth in today’s market if it were 

sold in an orderly fashion to a willing buyer. Before mark-to-market accounting took 

effect, the Financial Accounting Standards Board (FASB) produced much evidence 

to show that valuing financial instruments and other difficult-to-price assets by ‘‘historical’’ costs, or ‘‘mark to management,’’ was folly. 

The rules now under attack are neither as significant nor as inflexible as critics 

charge. Mark-to-market accounting is generally limited to investments held for trading purposes, and to certain derivatives. For many financial institutions, these investments represent a minority of their total investment portfolio. For example, 

Bloomberg columnist David Reilly reports that of the 12 largest banks in the KBW 

Bank Index, only 29 percent of the $8.46 trillion in assets are at MTM prices. 21
195 

prices. Yet these loans still produce losses, thanks to the housing meltdown and recession. In 

fact, bank losses on unmarked loans are typically bigger than mark-to-market losses on securities like bonds backed by mortgages.’’ 22SEC, Office of the Chief Accountant, Report and Recommendations Pursuant to Section 133 

of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-Market Accounting 

(available at: http://www.sec.gov/news/studies/2008/marktomarket123008.pdf). The report 

concludes: ‘‘The Staff observes that fair value accounting did not appear to play a meaningful 

role in bank failures occurring during 2008. Rather, bank failures in the U.S. appeared to be 

the result of growing probable credit losses, concerns about asset quality, and, in certain cases, 

eroding lender and investor confidence. For the failed banks that did recognize sizable fair value 

losses, it does not appear that the reporting of these losses was the reason the bank failed.’’ 

At 4. 

Why is that so? Most bank assets are in loans, which are held at their original 

cost using amortization rules, minus a reserve that banks must set aside as a safety 

cushion for potential future losses. 

MTM rules also give banks a choice. MTM accounting is not required for securities held to maturity, but you need to demonstrate a ‘‘positive intent and ability’’ 

that you will do so. Further, an SEC 2008 report found that ‘‘over 90 percent of investments mark-to-market are valued based on observable inputs.’’ 22

Obfuscating sound accounting rules by gutting MTM rules will only further reduce investors’ trust in the financial statements of all companies, causing private 

capital—desperately needed in securities markets—to become even scarcer. Worse, 

decreased clarity will further erode confidence in the American economy, with dire 

consequences for many of the financial institutions who are calling for MTM 

changes. 

Greater transparency is also necessary in the over-the-counter derivatives markets. These markets play a critical role in the establishment of prices in almost 

every public or regulated market, from determining interest rates to share prices. 

Reducing the need for reliance on a few opaque counterparties, increasing regulatory access to price and volume and other transactional information, and fostering 

integrity in the price discovery function for OTC products that affect the borrowing 

costs of individual companies, are all objectives that should be aggressively pursued 

as part of this Committee’s modernization of our financial regulatory structure. 

VI. Conclusion 

Honesty and fair dealing are at the foundation of the investor confidence our markets enjoyed for so many years. A sustainable economic recovery will not occur until 

investors can again feel certain that their interests come first and foremost with the 

companies, asset managers, and others with whom they invest their money, and 

until they believe that regulators are effectively safeguarding them against fraud. 

CPIC is committed to working diligently with this Committee and other policy makers to achieve that difficult but necessary goal. 

PREPARED STATEMENT OF BARBARA ROPER 

DIRECTOR OF INVESTOR PROTECTION, 

CONSUMER FEDERATION OF AMERICA

MARCH 26, 2009 

Chairman Dodd, Ranking Member Shelby, and Members of the Committee: My 

name is Barbara Roper. I am Director of Investor Protection of the Consumer Federation of America (CFA). CFA is a nonprofit association of approximately 280 organizations. It was founded in 1968 to advance the consumer interest through research, advocacy, and education. I appreciate the opportunity to appear before you 

today to discuss needed steps to strengthen investor protection. 

The topic we have been asked to address today, ‘‘Enhancing Investor Protection 

and the Regulation of Securities Markets,’’ is broad. It is appropriate that you begin 

your regulatory reform efforts by casting a wide net, identifying the many issues 

that should be addressed as we seek to restore the integrity of our financial system. 

In response, my testimony will also be broader than it is deep. In it, I will attempt 

to identify and briefly describe, but not comprehensively detail, solutions to a number of problems in three general categories: responding to the current financial crisis, reversing harmful policies, and adopting pro-investor reforms. I look forward to 

working with this Committee and its members on its legislative response. 
196 

Introduction 

Before I turn to specific issues, however, I would like to take a few moments to 

discuss the environment in which this reform effort is being undertaken. I’m sure 

I don’t need to tell the members of this Committee that the public is angry, or that 

investor confidence—not just in the safety of the financial markets but in their integrity—is at an all-time low. Perhaps you’ve seen the recent Harris poll, taken before the news hit about AIG’s million-dollar bonuses, which found that 71 percent 

of respondents agreed with the statement that, ‘‘Most people on Wall Street would 

be willing to break the law if they believed they could make a lot of money and get 

away with it.’’ If not, you’ve surely heard a variant on this message when you’ve 

visited your districts or turned on the evening news. 

Right now, the public rage is unfocused, or rather it is focused on shifting targets 

in response to the latest headlines: Bernie Madoff’s Ponzi scheme one day, bailout 

company conferences at spa resorts the next, AIG bonuses today. Imagine what will 

happen if the public ever really wakes up to the fact that all of the problems that 

have brought down our financial system and sent the global economy into deep recession—unsound and unsustainable mortgage lending, unregulated over-thecounter derivatives, and an explosive combination of high leverage and risky assets 

on financial institution balance sheets—were diagnosed years ago but left 

unaddressed by legislators and regulators from both political parties who bought 

into the idea that market discipline and industry self-interest were all that was 

needed to rein in Wall Street excesses and that preserving industry’s ability to innovate was more important than protecting consumers and investors when those innovations turned toxic. 

Now, this Committee and others in Congress have begun the Herculean task of 

rewriting the regulatory rulebook and restructuring the regulatory system. That is 

an effort that CFA strongly supports. But, as the Securities Subcommittee hearing 

last week on risk management regulation made all too clear, those efforts are likely 

to have little effect if regulators remain reluctant to act in the face of obvious industry shortcomings and clear signs of abuse. After all, we might not be here today if 

regulators had done just that—if the Fed had used its authority under the Home 

Ownership and Equity Protection Act to rein in the predatory subprime lending that 

is at the root of this problem, or if SEC and federal banking regulators had required 

the institutions under their jurisdiction to adopt appropriate risk management practices that could have made them less vulnerable to the current financial storm. 

Before we heap too much scorn on the regulators, however, we would do well to 

remember that, in recent years at least, global competitiveness was the watchword, 

and regulators who took too tough a line with industry were more likely to be called 

on the carpet than those who were too lax. Even now, it is not clear how much that 

has changed. After all, just two weeks ago, the House Capital Markets Subcommittee subjected the Financial Accounting Standards Board (FASB) to a thorough grilling for doing too little to accommodate financial institutions seeking 

changes to fair value accounting, changes, by the way, that would make it easier 

for those institutions to hide bad news about the deteriorating condition of their balance sheets from investors and regulators alike. Unless something fundamental 

changes in the way we approach these issues, it is all too easy to imagine a new 

systemic risk regulator sitting in that same hot seat in a couple of years, asked to 

defend regulations industry groups complain are stifling innovation and undermining their global competitiveness. More than any single policy or practice, that 

antiregulatory bias among regulators and legislators is what needs to change if the 

goal is to better protect investors and restore the health and integrity of our securities markets. 

I. Respond to the Current Financial Crisis 

It doesn’t take a rocket scientist to recognize that, in the midst of a financial crisis 

of global proportions, the top investor protection priority today must be fixing the 

problems that caused the financial meltdown. Largely as the result of a coincidence 

in the timing of Bear Stearns’ failure and the release of the Treasury Department’s 

Blueprint for Financial Regulatory Reform, many people have sought solutions to 

our financial woes in a restructuring of the financial regulatory system. CFA certainly agrees that our regulatory structure can, and probably should, be improved. 

We remain convinced, however, that structural weaknesses were not a primary 

cause of the current crisis, and structural changes alone will not prevent a recurrence. We appreciate the fact that this Committee has recognized the importance 

of treating these issues holistically and has pledged to take an inclusive approach. 

As the Committee moves forward with that process, the following are among the key 

investor protection issues CFA believes must be addressed as part of a comprehensive response to the financial meltdown. 
197 

1Frank Partnoy, Infectious Greed, How Deceit and Risk Corrupted the Financial Markets, 

Henry Holt and Company (New York), 2003, p. 123. 

1. Shut down the ‘‘shadow’’ banking system 

The single most important step Congress can and should take immediately to reduce excessive risks in the financial system is to close down the shadow banking 

system completely and permanently. While progress is apparently being made (however slowly) in moving over-the-counter credit default swaps onto a clearinghouse, 

this is just a start, and a meager start at that. Meaningful financial regulatory reform must require that all financial activities be conducted in the light of regulatory 

oversight according to basic rules of transparency, fair dealing, and accountability. 

As Frank Partnoy argued comprehensively and persuasively in his 2003 book, Infectious Greed, a primary use of the ‘‘shadow’’ banking system—and indeed the 

main reason for its existence—is to allow financial institutions to do indirectly what 

they or their clients would not be permitted to do directly in the regulated markets. 

So, when Japanese insurers in the 1980s wanted to evade restrictions that prevented them from investing in the Japanese stock market, Bankers Trust designed 

a complex three-way derivative transaction between Japanese insurers, Canadian 

bankers, and European investors that allowed them to do just that. Institutional investors that were not permitted to speculate in foreign currencies could do so indirectly using structured notes designed by Credit Suisse Financial Products that, incidentally, magnified the risks inherent in currency speculation. And banks could 

do these derivatives deals through special purpose entities (SPEs) domiciled in business-friendly jurisdictions like the Cayman Islands in order to avoid taxes, keep details of the deal hidden, and insulate the bank from accountability. 

These same practices, which led to a series of mini-financial crises throughout the 

1990s, are evident in today’s crisis, but on a larger scale. Banks such as Citigroup 

were still using unregulated special purpose entities to hold toxic assets that, if held 

on their balance sheets, would have required them to set aside additional capital, 

relying on the fiction that the bank itself was not exposed to the risks. Investment 

banks such as Merrill Lynch sold subprime-related CDOs to pension funds and 

other institutional investors in private placements free from disclosure and other obligations of the regulated marketplace. And everyone convinced themselves that 

they were protected from the risks of those toxic assets because they had insured 

them using credit default swaps sold in the over-the-counter derivatives market, 

often by AIG, without the basic protections that trading on an exchange would provide, let alone the reserve or collateral requirements that would, in the regulated 

insurance market, provide some assurance that any claims would be paid. 

To be credible, any proposal to respond to the current crisis must confront the 

‘‘shadow banking system’’ issue head-on. This does not mean that all investors must 

be treated identically or that all financial activities must be subject to identical regulations, but it does mean that all aspects of the financial system must be subject 

to regulatory scrutiny based on appropriate standards. One focus of that regulation 

should be on protecting against risks that could spill over into the broader economy. 

But regulation should also apply basic principles of transparency, fair dealing, and 

accountability to these activities in recognition of the two basic lessons from the current crisis: 1) protecting consumers and investors contributes to the safety and stability of the financial system; and 2) the sheer complexity of modern financial products has made former measures of investor ‘‘sophistication’’ obsolete. 

The basic justification for allowing two systems to grow up side-by-side—one regulated and one not—is that sophisticated investors do not require the protections of 

the regulated market. According to this line of reasoning, these investors are capable both of protecting their own interests and of absorbing any losses. That myth 

should have been dispelled back in the early 1990s, when Bankers Trust took ‘‘sophisticated’’ investors, such as Gibson Greeting, Inc. and Procter & Gamble, to the 

cleaners selling them risky interest rate swaps based on complex formulas that the 

companies clearly didn’t understand. Or when Orange County, California lost $1.7 

billion, and ultimately went bankrupt, buying structured notes with borrowed 

money in what essentially amounted to a $20 billion bet that interest rates would 

remain low indefinitely. Or when a once-respected conservative government bond 

fund, Piper Jaffray Institutional Government Income Portfolio, lost 28 percent of its 

value in less than a year betting on collateralized mortgage obligations that involved 

‘‘risks that required advanced mathematical training to understand.’’ 1

All of these deals, and many others like them, had several characteristics in common. In each case, the brokers and bankers who structured and sold the deal made 

millions while the customers lost fortunes. The deals were all carried out outside 

the regulated securities markets, where brokers, despite their best lobbying efforts 
198 

2Partnoy, p. 55, citing Brett D. Fromson, ‘‘Guess What? The Loss is Now . . . $20 Million: 

How Bankers Trust Sold Gibson Greetings a Disaster,’’ Washington Post, June 11, 1995, p. A1. 3 Jill Drew, ‘‘Frenzy,’’ Washington Post, December 16, 2008, p. A1. 4 Jerome S. Fons and Frank Partnoy, ‘‘Rated F for Failure,’’ New York Times, March 16, 2009. 

throughout much of the 1990s, still faced a suitability obligation in their dealings 

with institutional clients. Once the deals blew up, efforts to recover losses were almost entirely unsuccessful. And, in many cases, strong evidence suggests that the 

brokers and bankers knowingly played on these ‘‘sophisticated’’ investors’ lack of sophistication. Partnoy offers the following illustration of the culture at Bankers 

Trust: 

As one former managing director put it, ‘‘Guys started making jokes on the 

trading floor about how they were hammering the customers. They were 

giving each other high fives. A junior person would turn to his senior guy 

and say, ‘I can get [this customer] for all these points.’ The senior guys 

would say, ‘Yeah, ream him.’ ’’ 2

More recent accounts suggest that little has changed in the intervening decades. 

As Washington Post reporter Jill Drew described in a story detailing the sale of 

subprime CDOs: 

The CDO alchemy involved extensive computer modeling, and those who 

wanted to wade into the details quickly found that they needed a PhD in 

mathematics. 

But the team understood the goal, said one trader who spoke on condition 

of anonymity to protect her job: Sell as many as possible and get paid the 

most for every bond sold. She said her firm’s salespeople littered their 

pitches to clients with technical terms. They didn’t know whether their 

pitches made sense or whether the clients understood. 3

The sophisticated investor myth survived earlier scandals thanks to Wall Street 

lobbying and the fact that the damage from these earlier scandals was largely selfcontained. What’s different this time around is the harm that victimization of ‘‘sophisticated’’ investors has done to the broader economy. Much as they had in the 

past, ‘‘sophisticated’’ institutional investors have once again loaded up on toxic assets—in this case primarily mortgage-backed securities and collateralized debt obligations—without understanding the risks of those investments. In an added twist 

this time around, many financial institutions also remained exposed to the risk of 

these assets, either because they made a conscious decision to retain a portion of 

the investments or because they couldn’t sell off their inventory after the market 

collapsed. As events of the last year have shown, the damage this time is not selfcontained; it has led to a 50 percent drop in the stock market, a freezing of credit 

markets, and a severe global recession. Meanwhile, the administration is still struggling to find a way to clear toxic assets from financial institutions’ balance sheets. 

Once it has closed existing gaps in the regulatory system, Congress will still need 

to give authority to some entity—presumably whatever entity is designated as systemic risk regulator—to prevent financial institutions from opening up new regulatory loopholes as soon as the old ones are closed. That regulator must have the 

ability to determine where newly emerging activities will be covered within the regulatory structure. In making those decisions, the governing principle should be that 

activities and products are regulated according to their function. For example, 

where credit default swaps are used as a form of insurance, they should be regulated according to standards that are appropriate to insurance, with a focus on ensuring that the writer of the swaps will be able to make good on any claims. The 

other governing principle should be that financial institutions are not permitted to 

engage in activities indirectly that they would be prohibited from engaging in directly. Until that happens, anything else Congress does to reduce the potential for 

systemic risks is likely to have little effect. 

2. Strengthen regulation of credit rating agencies 

Complex derivatives and mortgage-backed securities were the poison that contaminated the financial system, but it was their ability to attract high credit ratings 

that allowed them to penetrate every corner of the market. Over the years, the 

number of financial regulations and other practices tied to credit ratings has grown 

rapidly. For example, money market mutual funds, bank capital standards, and 

pension fund investment policies all rely on credit ratings to one degree or another. 

As Jerome S. Fons and Frank Partnoy wrote in a recent New York Times op ed: 

‘‘Over time, ratings became valuable . . . because they ‘‘unlock’’ markets; that is, 

they are a sort of regulatory license that allows money to flow.’’ 4 This growing reli-
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5 Joseph R. Mason and Joshua Rosner, How Resilient Are Mortgage Backed Securities to 

Collateralized Debt Obligation Market Disruptions? (preliminary paper presented at Hudson Institute) February 15, 2007. 6Gretchen Morgenson, ‘‘Debt Watchdogs: Tamed or Caught Napping?’’ New York Times, December 7, 2008. 7 U.S. Securities and Exchange Commission, Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies, July 2008. 

ance on credit ratings has come about despite their abysmal record of under-estimating risks, particularly the risks of arcane derivatives and structured finance 

deals. Although there is ample historical precedent, never was that more evident 

than in the current crisis, when thousands of ultimately toxic subprime-related 

mortgage-backed securities and CDOs were awarded the AAA ratings that made 

them eligible for purchase by even the most conservative of investors. 

Looking back, many have asked what would possess a ratings agency to slap a 

AAA rating on, for example, a CDO composed of the lowest-rated tranches of a 

subprime mortgage-backed security. (Some, like economists Joshua Rosner and Joseph Mason, pointed out the flaws in these ratings much earlier, at a time when, 

if regulators had heeded their warning, they might have acted to address the risks 

that were lurking on financial institutions’ balance sheets.) 5 Money is the obvious 

answer. Rating structured finance deals pays generous fees, and ratings agencies’ 

profitability has grown increasingly dependent in recent years on their ability to win 

market share in this line of business. Within a business model where rating agencies are paid by issuers, the perception at least is that they too often win business 

by showing flexibility in their ratings. Another possibility, no more attractive, is 

that the agencies simply weren’t competent to rate the highly complex deals being 

thrown together by Wall Street at a breakneck pace. One Moody’s managing director 

reportedly summed up the dilemma this way in an anonymous response to an internal survey: ‘‘These errors make us look either incompetent at credit analysis or like 

we sold our soul to the devil for revenue, or a little bit of both.’’ 6

The Securities and Exchange Commission found support for both explanations in 

its July 2008 study of the major ratings agencies. 7 It documented both lapses in 

controls over conflicts of interest and evidence of under-staffing and shoddy practices: assigning ratings despite unresolved issues, deviating from models in assigning ratings, a lack of due diligence regarding information on which ratings are 

based, inadequate internal audit functions, and poor surveillance of ratings for continued accuracy once issued. Moreover, in addition to the basic conflict inherent in 

the issuer-paid model, credit rating agencies can be under extreme pressure from 

issuers and investors alike to avoid downgrading a company or its debt. With credit 

rating triggers embedded in AIG’s credit default swaps agreements, for example, a 

small reduction in rating exposed the company to billions in obligations and threatened to disrupt the CDS market. 

It is tempting to conclude, as many have done, that the answer to this problem 

is simply to remove all references to credit ratings from our financial regulations. 

This is the recommendation that Fons and Partnoy arrive at in their Times op ed. 

‘‘Regulators and investors should return to the tool they used to assess credit risk 

before they began delegating responsibility to the credit rating agencies,’’ they conclude. ‘‘That tool is called judgment.’’ Unfortunately, Fons and Partnoy may have 

identified the only thing less reliable than credit ratings on which to base our investor protections. 

The other frequently suggested solution is to abandon the issuer-paid business 

model. Simply moving to an investor-paid model suffers from two serious shortcomings, however. First, it is not as free from conflicts as it may on the surface appear. While investors generally have an interest in receiving objective information 

before they purchase a security—unless they are seeking to evade standards they 

view as excessively restrictive—they may be no more interested than issuers in seeing a security downgraded once they hold it in their portfolio. Moreover, we stand 

to lose ratings transparency under a traditional investor-paid model, since investors 

who purchase the rating are unlikely to want to share that information with the 

rest of the world on a timely basis. SEC Chairman Mary Schapiro indicated in her 

confirmation hearing before this Committee that she was exploring other payment 

models designed to get around these problems. We look forward to reviewing concrete suggestions that could form an important part of any comprehensive solution 

to the credit rating problem. 

While it is easier to diagnose the problems with credit ratings than it is to prescribe a solution, we believe the best approach is found in simultaneously reducing 

reliance on ratings, increasing accountability of ratings agencies, and improving regulatory oversight. Without removing references to ratings from our legal require-
200 

ments entirely, Congress could reduce reliance on ratings by clarifying, in each 

place where ratings are referenced, that reliance on ratings does not substitute for 

due diligence. So, for example, a money market fund would still be restricted to investing in bonds rated in the top two categories, but they would also be accountable 

for conducting meaningful due diligence to determine that the investment in question met appropriate risk standards. 

At the same time, credit rating agencies must lose the First Amendment protection that shields them from accountability. Although we cannot be certain, we believe ratings agencies would have been less tolerant of the shoddy practices uncovered in the SEC study and congressional hearings if they had known that investors 

who relied on those ratings could hold them accountable in court. First Amendment 

protections based on the notion that ratings are nothing more than opinions are inconsistent with the ratings agencies’ legally recognized status and their legally sanctioned gatekeeper function in our markets. Either their legal status or their protected status must go. As noted above, we believe the best approach is to retain 

their legal function but to add the accountability that is appropriate to that function. 

Finally, while we appreciate the steps Congress, and this Committee in particular, 

took in 2006 to enhance SEC oversight of ratings agencies, we believe this legislation stopped short of the comprehensive reform that is needed. New legislation 

should specifically address issues raised by the SEC study (a study made possible 

by the earlier legislation), such as lack of due diligence regarding information on 

which ratings are based, weaknesses in post-rating surveillance to ensure continued 

accuracy, and inadequacy of internal audits. In addition, it should give the SEC express authority to oversee ratings agencies comparable to the authority the Sarbanes-Oxley Act granted the PCAOB to oversee auditors. In particular, the agency 

should have authority to examine individual ratings engagements to determine not 

only that analysts are following company practices and procedures but that those 

practices and procedures are adequate to develop an accurate rating. Congress 

would need to ensure that any such oversight function was adequately funded and 

staffed. 

3. Address risks created by securitization 

Few practices illustrate better than securitization the capacity for market innovations to both bring tremendous benefits and do enormous harm. On the one hand, 

securitization makes it possible to expand consumer and business access to capital 

for a variety of beneficial purposes. It was already evident by the late 1990s, however, that securitization had fundamentally altered underwriting practices in the 

mortgage lending market. By the middle of this decade, it was glaringly obvious to 

anyone capable of questioning the wisdom of the market that lenders were responding to those changes by writing huge numbers of unsustainable mortgages. Unfortunately, the Fed, which had the power to rein in unsound lending practices, was 

among the last to wake up to the systemic risks that they posed. 

In belated recognition that incentives had gotten out of whack, many are now advocating that participants in securitization deals be required to have ‘‘skin in the 

game,’’ in the form of some retained exposure to the risks of the deal. This is an 

approach that CFA supports, although we admit it is easier to describe in theory 

than to design in practice. We look forward to working with the Committee as it 

seeks to do just that. However, we also caution against putting exclusive faith in 

this approach. Given the massive fees that lenders and underwriters have earned, 

it will be difficult to design an incentive strong enough to counter the lure of high 

fees. Financial regulators will need to continue to monitor for signs that lenders are 

once again abandoning sound lending practices and use their authority to rein in 

those practices wherever they find them. 

Another risk associated with securitization has gotten less attention, though it is 

at the heart of the difficulties the administration now faces in restoring the financial system. Their sheer complexity makes it extremely difficult, if not impossible 

to unwind these deals. As a result, that very complexity becomes a source of systemic risk. New standards to counteract this design flaw should be included in any 

measure to reduce securitization risks. 

4. Improve systemic risk regulation 

Contrary to conventional wisdom, the current crisis did not stem from the lack 

of a regulator with sufficient information and the tools necessary to protect the financial system as a whole against systemic risks. In the key areas that contributed 

to the current crisis—unsound mortgage lending, the explosive combination of risky 

assets and excessive leverage on financial institutions’ balance sheets, and the 

growth of an unregulated ‘‘shadow’’ banking system—regulators had all the informa-
201 

tion they needed to identify the crucial risks that threatened our financial system 

but either didn’t use the authority they had or, in the case of former CFTC Chair 

Brooksley Born, were denied the authority they requested to rein in those risks. Unless that reluctance to regulate changes, simply designating and empowering a systemic risk regulator is unlikely to have much effect. 

Nonetheless, CFA agrees that, if accompanied by a change in regulatory approach 

and adoption of additional concrete steps to reduce existing systemic threats, designating some entity to oversee systemic risk regulation could enhance the quality of 

systemic risk oversight going forward. Financial Services Roundtable Chief Executive and CEO Steve Bartlett summed up the problem well in earlier testimony before the Senate Banking Committee when he said that the recent crisis had revealed 

that our regulatory system ‘‘does not provide for sufficient coordination and cooperation among regulators, and that it does not adequately monitor the potential for 

market failures, high-risk activities, or vulnerable interconnections between firms 

and markets that can create systemic risk.’’ 

In keeping with that diagnosis of the problem, CFA believes the goals of systemic 

risk regulation should be: 1) to ensure that risks that could threaten the broader 

financial system are identified and addressed; 2) to reduce the likelihood that a 

‘‘systemically significant’’ institution will fail; 3) to strengthen the ability of regulators to take corrective actions before a crisis to prevent imminent failure; and 4) 

to provide for the orderly failure of nonbank financial institutions. The latter point 

deserves emphasis, because this appears to be a common misconception: the goal of 

systemic risk regulation is not to protect certain ‘‘systemically significant’’ institutions from failure, but rather to simultaneously reduce the likelihood of such a failure and ensure that, should it occur, there is a mechanism in place to allow that 

to happen with the minimum possible disruption to the broader financial markets. 

Although there appears to be near universal agreement about the need to improve 

systemic risk regulation, strong disagreements remain in some areas regarding the 

best way to accomplish that goal. Certain issues we believe are clear: (1) systemic 

risk regulation should not be focused exclusively on a few ‘‘systemically significant’’ 

institutions; (2) the systemic risk regulator should have broad authority to survey 

the entire financial system; (3) regulatory oversight should be an on-going responsibility, not emergency authority that kicks in when we find ourselves on the brink 

of a crisis; (4) it should include authority to require corrective actions, not just survey for risks; (5) it should, to the degree possible, build incentives into the system 

to discourage private parties from taking on excessive risks and becoming too big 

or too inter-connected to fail; and (6) it should include a mechanism for allowing the 

orderly unwinding of troubled or failing nonbank financial institutions. 

CFA has not yet taken a position on the controversial question of who should be 

the systemic risk regulator. Each of the approaches suggested to date—assigning 

this responsibility to the Federal Reserve, creating a new agency to perform this 

function, or relying on a panel of financial regulators to coordinate systemic risk 

regulation—has its flaws, and it is far easier to poke holes in the various proposals 

than it is to design a fool-proof system for improving risk regulation. Problems that 

have been identified with assigning this role to the Fed strike us as particularly difficult to overcome. Regardless of the approach Congress chooses to adopt, it will 

need to take steps to address the weaknesses of that particular approach. One step 

we urge Congress to take, regardless of which approach it chooses, is to appoint a 

high-level advisory panel of independent experts to consult on issues related to systemic risk. 

Such a panel could include academics and other analysts from a variety of disciplines with a reputation for independent thinking and, preferably, a record of identifying weaknesses in the financial system. Names such as Nouriel Roubini, Frank 

Partnoy, Joseph Mason, and Joshua Rosner immediately come to mind as attractive 

candidates for such an assignment. The panel would be charged with conducting an 

ongoing and independent assessment of systemic risks to supplement the efforts of 

the regulators. It would report periodically to both Congress and the regulatory 

agencies on its findings. It could be given privileged access to information gathered 

by the regulators to use in making its assessment. When appropriate, it might recommend either legislative or regulatory changes with a goal of reducing risks to the 

financial system. CFA believes such an approach would greatly enhance the accountability of regulators and reduce the risks of group-think and complacency. 

The above discussion merely skims the surface of issues related to systemic risk 

regulation. Included at the back of this document is testimony CFA presented last 

week in the House Financial Services Committee that goes into greater detail on 

the various strengths and weaknesses of the different approaches that have been 

suggested to enhance systemic risk regulation and, in particular, the issue of who 

should regulate. 
202 

5. Reform executive compensation practices 

Executive pay practices appear to have contributed to excessive risk-taking at financial institutions. Those who have analyzed the issues have typically identified 

two factors that contributed to the problem: (1) a short-term time horizon for incentive pay that allows executives to cash out before the consequences of their actions 

are apparent; and (2) compensation practices, such as through stock options, that 

provide unlimited up-side potential while effectively capping down-side exposure. 

While the first encourages executives to focus on short-term results rather than 

long-term growth, the latter may make them relatively indifferent to the possibility 

that things could go wrong. As AFL–CIO General Counsel Damon Silvers noted in 

recent testimony before the House Financial Services Committee, this is ‘‘a terrible 

way to incentivize the manager of a major financial institution, and a particularly 

terrible way to incentivize the manager of an institution the Federal government 

might have to rescue.’’ Silvers further noted that adding large severance packages 

to the mix further distorts executive incentives: ‘‘If success leads to big payouts, and 

failure leads to big payouts, but modest achievements either way do not, then there 

is once again a big incentive to shoot for the moon without regard to downside risk.’’ 

In keeping with this analysis, we believe executive compensation practices at financial institutions should be examined for their potential to create systemic risk. 

Practices such as tying incentive pay to longer time horizons, encouraging payment 

in stock rather than options, and including claw-back provisions should be encouraged. As with other practices that contribute to systemic risk, compensation practices that do so could trigger higher capital requirements or larger insurance premiums as a way to make risk-prone compensation practices financially unattractive. 

At the same time, reforms that go beyond the financial sector are needed to give 

shareholders greater say in the operation of the companies they own, including 

through mandatory majority voting for directors, annual shareholder votes on company compensation practices, and improved proxy access for shareholders. This is 

the great unfinished business of the post-Enron era. Adoption of crucial reforms in 

this area should not be further delayed. 

6. Bring enforcement actions for law violations that contributed to the crisis 

CFA is encouraged by the changes we see new SEC Chairman Mary Schapiro 

making to reinvigorate the agency’s enforcement program. Mounting a tough and effective enforcement effort is essential both to deterring future abuses and to reassuring investors that the markets are fair and honest. While we recognize that 

many of the activities that led to the current crisis were legal, evidence suggests 

that certain areas deserve further investigation. Did investment banks fulfill their 

obligation to perform due diligence on the deals they underwrote? Did they provide 

accurate information to credit rating agencies rating those deals? Did brokers fulfill 

their obligation to make suitable recommendations? In many cases, violations of 

these standards may be out of reach of regulators, either because the sales were 

conducted through private placements or the products sold were outside the reach 

of securities laws. Nonetheless, we urge the agency to determine whether at least 

some of what appear to have been rampant abuses were conducted in ways that 

make them vulnerable to SEC enforcement authority. Such an investigation would 

not only be crucial to restoring investor confidence that the agency is committed to 

representing their interests, it could also provide regulators with a roadmap to use 

in identifying regulatory gaps that increase the potential for systemic risks. 

II. Reverse Harmful Policies 

Instead of identifying and addressing emerging risks that contributed to the current crisis, the SEC has devoted its energies in recent years to advancing a series 

of policy proposals that would reduce regulatory oversight, weaken investor protections, and limit industry accountability. In all but one case, these are issues that 

can be dealt with through a reversal in policy at the agency, and new SEC Chair 

Mary Schapiro’s statements at her confirmation hearing suggested that she is both 

aware of the problems and prepared to take a different course. The role of the Committee in these cases is simply to provide appropriate support and oversight to ensure that those efforts remain on track. The other issue, where this Committee can 

play a more direct role, is in ensuring that the SEC receives the resources it needs 

to mount an effective regulatory and enforcement program. 

1. Increase funding for the SEC 

The new SEC chairman inherited a broken and demoralized agency. By all accounts, she has begun to undertake the thorough overhaul that the situation demands. Some, but not all, of the needed changes can be accomplished within the 

agency’s existing budget, but others (such as upgrading agency technology) will re-
203 

quire an infusion of funds. Moreover, while we recognize this Committee played an 

important role in securing additional funds for the agency in the wake of the accounting scandals earlier in this decade, we are convinced that the agency remains 

under-funded and under-staffed to fulfill its assigned responsibilities. 

Perhaps you recall a study Chairman Dodd commissioned in 1988 to explore the 

possibility of self-funding for the SEC. It documented the degree to which the agency had been starved for resources during the preceding decade, a period in which 

its workload had undergone rapid growth. Although agency resources experienced 

more volatility in the 1990s—with years that saw both significant increases and 

substantial cuts—the overall picture was roughly the same: a funding level that did 

not keep pace with either the market’s overall growth or, of even greater concern, 

the dramatic increase in market participation by average, unsophisticated retail investors. 

After the Enron and Worldcom scandals, Congress provided a welcome and dramatic increase in funding. Certainly, the approximate doubling of the agency’s budget was as much as the SEC could be expected to absorb in a single year. Operating 

under the compressed timeline that the emergency demanded, however, no effort 

was made at that time to thoroughly assess what funding level was needed to allow 

the agency to fulfill its regulatory mandate. The previous Chairman proved reluctant to request additional resources once the original infusion of cash was absorbed. 

We believe that the time has come to conduct an assessment, comparable to the review provided by this Committee in 1988, of the agency’s resource needs. Once conducted, that review could provide the basis for a careful, staged increase in funding 

targeted at specific shortcomings in agency operations. 

2. Halt mutual recognition negotiations 

Last August, the SEC announced that it had entered a mutual recognition agreement with Australia that would allow eligible Australian stock exchanges and 

broker-dealers to offer their services to certain types of U.S. investors and firms 

without being subject to most SEC regulation. At the same time, the agency announced that it was negotiating similar agreements with other jurisdictions. The 

agency adopted this radical departure in regulatory approach without first assessing 

its potential costs, risks and unintended consequences, without setting clear standards to be used in determining whether a country qualifies for mutual recognition 

and submitting them for public comment, and without offering any evidence that 

this regulatory approach is in the public interest. 

It is our understanding that, thanks in part to the intervention of members of this 

Committee, this agreement has not yet been implemented. We urge members of this 

Committee to continue to work with the new SEC Chair to ensure that no further 

actions are taken to implement a mutual recognition policy at least until the current 

financial crisis is past. At a bare minimum, we believe any decision to give further 

consideration to mutual recognition must be founded on a careful assessment of the 

potential risks of such an approach, clear delineation of standards that would be 

used to assess whether another jurisdiction would qualify for such treatment, and 

transparency regarding the basis on which the agency made that determination. 

CFA believes, however, that this policy is ill-advised even under the best of circumstances, since no other jurisdiction is likely to place as high a priority on protecting U.S. investors as our own regulators. As such, we believe the best approach 

is simply to abandon this policy entirely and to focus instead on promoting cooperation with foreign regulators on terms that increase, rather than decrease, investor 

protections. 

At the same time, we urge Congress and the SEC to work with the Public Company Accounting Oversight Board (PCAOB) to ensure that it does not proceed with 

its similarly ill-conceived proposal to rely on foreign audit oversight boards to conduct inspections of foreign audit firms that play a significant role in the audits of 

U.S. public companies. This proposal is, in some ways, even more troubling than the 

SEC’s mutual recognition proposal, since the oversight bodies to be relied are, many 

of them, still in their infancy, lack adequate resources, and do not meet the Sarbanes-Oxley Act’s standards for independence. Prior to issuing this proposal, the 

PCAOB had focused its efforts on developing a program of joint inspections that is 

clearly in the best interests of U.S. and foreign investors alike. This proposed 

change in policy at the PCAOB has thrown that program into jeopardy, and it is 

important that it be gotten back on track. 

3. Do not approve the IFRS Roadmap 

In a similar vein, the SEC has recently proposed to abandon a long and fruitful 

policy of encouraging convergence between U.S. Generally Accepted Accounting 

Principles and International Financial Reporting Standards. In its place, the agency 
204 

has proposed to move rapidly toward U.S. use of international standards. Once 

again, the agency has proposed this change in policy without adequate regard to the 

potentially enormous costs of the transition, the loss of transparency that could result, or the strong opposition of retail and institutional investors to the proposal. 

We urge the Committee to work with the SEC to ensure that we return to a path 

of encouraging convergence of the two sets of standards so that, eventually, as that 

convergence is achieved, financial statements prepared under the two sets of standards would be comparable. 

4. Enhance investor representation on FASB 

In arguing against adoption of the IFRS roadmap, CFA has in the past cited 

IASB’s lack of adequate due process and susceptibility to industry and political influence. Unfortunately, FASB’s recent proposal to bow to industry pressure and 

weaken fair value accounting standards—and to do so after a mere two-week comment period and with no meaningful time for consideration of comments before a 

vote is taken—suggests that FASB’s vaunted independence and due process are 

more theoretical than real. We recognize and appreciate that leaders of this Committee have long shown a respect for the independence of the accounting standardsetting process. Moreover, we appreciate the steps that this Committee took, as part 

of the Sarbanes-Oxley Act, to try to enhance FASB’s independence. However, in 

light of recent events, CFA believes more needs to be done to shore up those reforms. Specifically, we urge you to strengthen the standards laid out in SOX for recognition of a standard-setting body by requiring that a majority of both the board 

itself and its board of trustees be investor representatives with the requisite accounting expertise. 

5. Ignore calls to weaken materiality standards and lessen issuer and auditor accountability for financial misstatements 

The SEC Advisory Committee on Improvements of Financial Reporting (CIFiR) released its final report last August detailing recommendations to ‘‘increase the usefulness of financial information to investors, while reducing the complexity of the 

financial reporting system to investors, preparers, and auditors.’’ While the report 

includes positive suggestions—including a suggestion to increase investor involvement in the development of accounting standards—it also includes anti-investor proposals to: (1) revise the guidance on materiality in order to make it easier to dismiss 

large errors as immaterial; (2) revise the guidance on when errors have to be restated to permit more material errors to avoid restatements; and (3) offer some form 

of legal protection to faulty professional judgments made according to a recommended judgment framework. Weakening investor protections in this way is illadvised at any time, but it is particularly so when we find ourselves in the midst 

of a financial crisis of global proportions. While we are confident that the new SEC 

Chair understands the need to strengthen, not weaken, financial reporting transparency, reliability, and accountability, we urge this Committee to continue to provide oversight in this area to ensure that these efforts remain on track. 

III. Adopt Additional Pro-Investor Reforms 

In addition to responding directly to the financial crisis and preventing a further 

deterioration of investor protections, there are important steps that Congress and 

the SEC can take to strengthen our markets by strengthening the protections we 

offer to investors. These include issues—such as regulation of financial professionals 

and restoring private remedies—that have already been raised in the context of financial regulatory reform. We look forward to a time, once the crisis is past, when 

we have the luxury of also returning our attention to additional issues, such as disclosure, mutual fund, and broker compensation reform, where a pro-investor agenda 

has languished and is in need of revival. For now, however, we will focus in this 

testimony only on the first set of issues. 

1. Adopt a rational, pro-investor policy for the regulation of financial professionals 

Reforming regulation of financial professionals has been a CFA priority for more 

than two decades, with precious little to show for it. Today, investment service providers who use titles and offer services that appear indistinguishable to the average 

investor are still regulated under two very different standards. In particular, brokers have been given virtually free rein to label their salespeople as financial advisers and financial consultants and to offer extensive personalized investment advice 

without triggering regulation under the Investment Advisers Act. 

As a result, customers of these brokers are encouraged to believe they are in an 

advisory relationship but are denied the protections afforded by the Advisers Act’s 

fiduciary duty and obligation to disclose conflicts of interest. Moreover, customers 

still don’t receive useful information to allow them to make an educated choice 
205 

8While we have discussed this approach here in the context of investment service providers, 

CFA believes this is an appropriate approach throughout the financial services industries: a 

suitability obligation for sales—whether of securities, insurance, mortgages or whatever—and an 

overriding fiduciary duty that applies in an advisory relationship. 

among different types of investment service providers. This inconsistent regulatory 

treatment and lack of effective pre-engagement disclosure are of particular concern 

given research that shows that the selection of an investment service provider is the 

last real investment decision many investors will ever make. Once they have made 

that choice, most are likely to rely on the recommendations they receive from that 

individual with little or no additional research to determine the costs or appropriateness of the investments recommended. 

Some now suggest that the efforts being undertaken by Congress to reform our 

regulatory system offer an opportunity to ‘‘harmonize’’ regulation of brokers, investment advisers, and financial planners. CFA agrees, but only so long as any ‘‘harmonization’’ strengthens investor protections. It is not clear that most proposals put 

forward to date meet that standard. Instead, the broker-dealer community appears 

to be trying to use this occasion to distract from the central issue—that brokers 

have over the years been allowed to transform themselves into advisers without 

being regulated as advisers—and to push an investment adviser SRO and a watered 

down ‘‘universal standard of care.’’ Unfortunately, this is one area where the new 

SEC Chairman’s Finra background appears to have influenced her thinking, and 

she echoed these sentiments during her confirmation hearing. It will therefore be 

incumbent on members of this Committee to ensure that investor interests predominate in any reforms that may be adopted to ‘‘harmonize’’ our system of regulating 

investment professionals. 

As a first principle, CFA believes that investment service providers should be regulated according to what they do rather than what type of firm they work for. Had 

the SEC implemented the Investment Advisers Act consistent with the clear intent 

of Congress, this would be the situation we find ourselves in today. That is water 

under the bridge, however, and we are long past the point where we can recreate 

the clear divisions that once was envisioned between advisory services and brokers’ 

transaction-based services. Instead, we believe the best approach is to clarify the responsibilities that go with different functions and to apply them consistently across 

the different types of firms. 8

• A Fiduciary Duty for Advice: All those who offer investment advice should be 

required to place their clients’ interests ahead of their own, to disclose material 

conflicts of interest, and to take steps to minimize those potential conflicts. That 

fiduciary duty should govern the entire relationship; it must not be something 

the provider adopts when giving advice but drops when selling the investments 

to implement recommendations. 

• A Suitability Obligation for Sales: Those who are engaged exclusively in a sales 

relationship should be subject to the know-your-customer and suitability obligations that govern brokers now. 

• No Misleading Titles: Those who choose to offer solely sales-based services 

should not be permitted to adopt titles that imply that they are advisers. Either 

they should be prohibited from using titles, such as financial adviser or financial consultant, designed to mislead the investor into thinking they are in an 

advisory relationship, or use of such titles should automatically carry with it 

a fiduciary duty to act in clients’ best interests. 

Because of the obvious abuses in this area that have grown up over the years, 

we have focused on the inconsistent regulatory treatment of advice offered by brokers, investment advisers, and financial planners. If, however, there are other services that investment advisers or financial planners are being permitted to offer outside the appropriate broker-dealer protections, we would apply the same principle 

to them. They should be regulated according to what they do, subject to the highest 

existing level of investor protections. 

One issue that has come up in this regard is whether investment advisers should 

be subject to oversight by a self-regulatory organization. The underlying argument 

here is that, while the Investment Advisers Act imposes a higher standard for advice, it is not backed by as robust a regulatory regime as that which governs brokerdealers. Finra has made no secret of its ambition to expand its authority in this 

area, at least with regard to the investment advisory activities of its broker-dealer 

member firms. There is at least a surface logic to this proposal. As Finra is quick 

to note, it brings significant resources to the oversight function and has rule-making 

authority that in some areas appears to go beyond that available to the SEC. 
206 

Despite that surface logic, there are several hurdles that Finra must overcome in 

making its case. The first is that Finra’s record of using its rule-making authority 

to benefit investors is mixed at best. Nowhere is that more evident than on this central question of the obligation brokers owe investors when they offer advice or portray themselves as advisers. For the two decades that this debate has raged, Finra 

and its predecessor, NASD regulation, have consistently argued this issue from the 

broker-dealer industry point of view. This is not an isolated instance. Finra has 

shown a similar deference to industry concerns on issues related to disclosure and 

arbitration. This is not to say that Finra never deviates from the industry viewpoint, but it does mean that investors must swim against a strong tide of industry 

opposition in pushing reforms and that those reforms, when adopted, tend to be 

timid and incremental in nature. 

This is, in our view, a problem inherent to self-regulation. Should Congress choose 

to place further reliance on bodies other than the SEC to supplement the agency’s 

oversight and rulemaking functions, it should at least examine what reforms are 

needed to ensure that those authorities are not captured by the industries they regulate and operate in a fully transparent and open fashion. We believe the governance model at the PCAOB offers a better model to ensure the independence of any 

body on which we rely to perform a regulatory function. 

The second issue regarding expanded Finra authority relates to its oversight 

record. It is ironic at best, cynical at worst, that Finra has tried to capitalize on 

its oversight failure in the Madoff case to expand its responsibilities to cover investment adviser activities. There may be good reasons why Finra’s predecessor, NASD 

Regulation, missed a fraud that operated under its nose for several decades. NASD 

Regulation was not, as we understand it, privy to the whistleblower reports that the 

SEC received. One factor that clearly was not responsible for NASD Regulation’s 

oversight failure, however, was its lack of authority over Madoff’s investment adviser operations. This should be patently obvious from the fact that there was no 

Madoff investment adviser for the first few decades in which the fraud was apparently being conducted. During that time, Madoff’s regulatory reports apparently indicated that he was engaged exclusively in proprietary trading and market making 

and did not have clients. NASD Regulation apparently did not take adequate steps 

to verify this information, despite general industry knowledge and extensive press 

reports to the contrary. 

What concerns us most about this situation is not that Finra missed the Madoff 

fraud. Individuals and institutions make mistakes, and the problems that lead to 

those mistakes can be corrected. We are far more concerned by what we view as 

Finra’s lack of honesty in accounting for this failure. That suggests a problem with 

the culture of the organization that is not as easily corrected. We have nothing but 

respect for new Finra President and CEO Rick Ketchum. However, the above analysis suggests he faces a significant task in overhauling Finra to make it more responsive to investor concerns, more effective in providing industry oversight, and 

more transparent in its dealings. Until that has been accomplished, we would caution against any expansion of Finra’s authority or any increased reliance on selfregulatory bodies generally. 

2. Restore private remedies 

In an era in which investors have been exposed to constantly expanding risks and 

repeated frauds, they have also experienced a continual erosion of their right to redress. This has occurred largely through unfavorable court decisions that have undermined investors’ ability to recover losses from those who aided the fraud and, 

with recent decisions on loss causation, even from those primarily responsible for 

perpetrating it. To restore balance and fairness to the system, CFA supports legislation to restore aiding and abetting liability, to eliminate the ability of responsible 

parties to avoid liability by manipulating disclosures, and to protect the ability of 

plaintiffs to aggregate small claims and access federal courts. 

CFA also supports the elimination of pre-dispute binding arbitration clauses in all 

consumer contracts, including those with securities firms. For many, even most investors, arbitration will remain the most attractive means for resolving disputes. 

However, not all cases are suitable for resolution in a forum that lacks a formal discovery process or other basic procedural protections. By forcing all cases into an industry-run arbitration process, regardless of suitability, binding arbitration clauses 

undermine investor confidence in the fairness of the system while making the system more costly and slower for all. While Finra has taken steps to address some 

of the worst problems, these reforms have been slow to come and have been incremental at best. We believe investors are best served by having a choice of resolution 

mechanisms that they are currently denied because of the nearly universal use of 

pre-dispute binding arbitration clauses. 
207 

Conclusion 

For roughly the past three decades, regulatory policy has been driven by an irrational faith that market discipline and industry self-interest could be relied on to 

rein in Wall Street excesses. Regulation was seen as, at best, a weak supplement 

to these market forces and, at worst, a burdensome impediment to innovation. The 

recent financial meltdown has proven the basic fallacy of that assumption. In October testimony before the House Oversight and Government Reform Committee, 

former Federal Reserve Chairman Alan Greenspan acknowledged, in clearer language than has been his wont, the basic failure of this regulatory approach: 

Those of us who looked to the self-interest of lending institutions to protect 

shareholders’ equity, myself included, are in a state of shocked disbelief. 

Such counterparty surveillance is a central pillar of our financial markets’ 

state of balance . . . If it fails, as occurred this year, market stability is 

undermined . . . 

I made a mistake in presuming that the self-interests of organizations, specifically banks and others, were such that they were best capable of protecting their own shareholders and their equity in the firms. 

Former Chairman Greenspan deserves credit for this forthright acknowledgement 

of error. 

What remains to be seen is whether Congress and the Administration will together devise a regulatory reform plan that reflects this fundamental shift. A bold 

and comprehensive plan is needed that restores basic New Deal regulatory principles and recognizes the role of regulation in preventing crises, not simply cleaning 

up in their wake. This approach, adopted in response to the Great Depression, 

brought us decades of economic growth, free from the recurring financial crises that 

have characterized the last several decades. If, on the other hand, policymakers do 

not acknowledge the pervasive and deep-seated flaws in financial markets, they will 

inevitably fail in their efforts to reform regulation, setting the stage for repeated crises and prompting investors to question not just the integrity and safety of our markets, but the ability of our policymakers to act in their interest. 

Even as we testify here today, Treasury Secretary Geithner is reportedly scheduled to present the Administration’s regulatory reform plan before another congressional committee. We will be subjecting that proposal and others that are developed 

as this process moves forward to a thorough analysis to determine whether it meets 

this standard: does the boldness and scope of the plan match the severity of the current crisis? We look forward to working with members of this Committee in the days 

and months ahead to craft a regulatory reform plan that meets this test and restores investors’ faith in the integrity of our markets and the effectiveness of our 

government. 

Appendix 

Testimony of Travis Plunkett, Legislative Director, Consumer Federation of America 

MARCH 17, 2009 

Mr. Chairman and Members of the Committee, my name is Travis Plunkett. I am 

Legislative Director of the Consumer Federation of America (CFA). CFA is a nonprofit association of 280 organizations that, since 1968, has sought to advance the 

consumer interest through research, advocacy, and education. 

I greatly appreciate the opportunity to appear before you today to testify about 

one of the most important issues Congress will need to address as it develops a comprehensive agenda to reform our Nation’s failed financial regulatory system—how 

to better protect the system as a whole and the broader economy from systemic 

risks. Recent experience has shown us that our current system was not up to the 

task, either of identifying significant risks, or of addressing those risks before they 

spun out of control, or of dealing efficiently and effectively with the situation once 

it reached crisis proportions. The effects of this failure on the markets and the economy have been devastating, rendering reform efforts aimed at protecting the system 

against systemic threats a top priority. 

In order to design an effective regulatory response, it is necessary to understand 

why the system failed. It has been repeated so often in recent months that it has 

taken on the aura of gospel, but it is simply not the case that the systemic risks 

that have threatened the global financial markets and ushered in the most serious 

economic crisis since the Great Depression arose because regulators lacked either 

sufficient information or the tools necessary to protect the financial system as a 

whole against systemic risks. (Though it is true that, once the crisis struck, regu-
208 

lators lacked the tools needed to deal with it effectively.) On the contrary, the crisis 

resulted from regulators’ refusal to heed overwhelming evidence and repeated warnings about growing threats to the system. 

• Former Congressman Jim Leach and former CFTC Chairwoman Brooksley Born 

both identified the potential for systemic risk in the unregulated over-thecounter derivatives markets in the 1990s. 

• Housing advocates have been warning the Federal Reserve since at least the 

early years of this decade that securitization had fundamentally changed the 

underwriting standards for mortgage lending, that the subprime mortgages 

being written in increasing numbers were unsustainable, that foreclosures were 

on the rise, and that this had the potential to create systemic risks. 

• The SEC’s risk examination of Bear Stearns had, according to the agency’s Inspector General, identified several of the risks in that company’s balance sheet, 

including its use of excessive leverage and an over-concentration in mortgagebacked securities. 

Contrary to conventional wisdom, these examples and others like them provide 

clear and compelling evidence that, in the key areas that contributed to the current 

crisis—unsound mortgage lending, the explosive combination of risky assets and excessive leverage on financial institutions’ balance sheets, and the growth of an unregulated ‘‘shadow’’ banking system—regulators had all the information they needed 

to identify the crucial risks that threatened our financial system but either didn’t 

use the authority they had or, in Born’s case, were denied the authority they needed 

to rein in those risks. 

Regulatory intervention at any of those key points had the potential to prevent, 

or at least greatly reduce the severity of, the current financial crisis—either by preventing the unsound mortgages from being written that triggered the crisis, or by 

preventing investment banks and other financial institutions from taking on excessive leverage and loading up their balance sheet with risky assets, leaving them vulnerable to failure when the housing bubble burst, or by preventing complex networks of counterparty risk to develop among financial institutions that allowed the 

failure of one institution to threaten the failure of the system as a whole. This view 

is well-articulated in the report of the Congressional Oversight Panel, which correctly identifies a fundamental abandonment of traditional regulatory principles as 

the root cause of the current financial crisis and prescribes an appropriately comprehensive response. 

So what is the lesson to be learned from that experience for Congress’s current 

efforts to enhance systemic risk regulation? The lesson is emphatically not that 

there is no need to improve systemic risk regulation. On the contrary, this should 

be among the top priorities for financial regulatory reform. But there is a cautionary 

lesson here about the limitations inherent in trying to address problems of inadequate systemic risk regulation with a structural solution. In each of the above examples, and others like them, the key problem was not insufficient information or 

inadequate authority; it was an unwillingness on the part of regulators to use the 

authority they had to rein in risky practices. That lack of regulatory will had its 

roots in an irrational faith among members of both political parties in markets’ ability to self-correct and industry’s ability to self-police. 

Until we abandon that failed regulatory philosophy and adopt in its place an approach to regulation that puts its faith in the ability and responsibility of government to serve as a check on industry excesses, whatever we do on systemic risk is 

likely to have little effect. Without that change in governing philosophy, we will simply end up with systemic risk regulation that exhibits the same unquestioning, market-fundamentalist approach that has characterized substantive financial regulation 

to a greater or lesser degree for the past three decades. 

If the ‘‘negative’’ lesson from recent experience is that structural solutions to systemic risk regulation will have limited utility without a fundamental change in regulatory philosophy, there is also a positive corollary. Simply closing the loopholes 

in the current regulatory structure, reinvigorating federal regulators, and doing an 

effective job at the day-to-day tasks of routine safety and soundness and investor 

and consumer protection regulation would go a long way toward eliminating the 

greatest threats to the financial system. 

The ‘‘Shadow’’ Banking System Represents the Greatest Systemic Threat 

In keeping with that notion, the single most significant step Congress could and 

should take right now to decrease the potential for systemic risk is to shut down 

the shadow banking system completely and permanently. While important progress 

is apparently being made (however slowly) in moving credit default swaps onto a 

clearinghouse, this is just a start, and a meager start at that. Meaningful financial 
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regulatory reform must require that all financial activities be conducted in the light 

of regulatory oversight according to basic rules of transparency, fair dealing, and accountability. 

As Frank Partnoy argued comprehensively and persuasively in his 2003 book, Infectious Greed, a primary use of the ‘‘shadow’’ banking system—and indeed the 

main reason for its existence—is to allow financial institutions to do indirectly what 

they or their clients would not be permitted to do directly in the regulated markets. 

So banks used unregulated special purpose entities to hold toxic assets that, if held 

on their balance sheets, would have required them to set aside additional capital, 

relying on the fiction that the bank itself was not exposed to the risks. Investment 

banks sold Mezzanine CDOs to pension funds in private placements free from disclosure and other obligations of the regulated marketplace. And everyone convinced 

themselves that they were protected from the risks of those toxic assets because 

they had insured them using credit default swaps sold in the over-the-counter market without the basic protections that trading on an exchange would provide, let 

alone the reserve or collateral requirements that would, in the regulated insurance 

market, provide some assurance that any claims would be paid. 

The basic justification for allowing two systems to grow up side-by-side—one regulated and one not—is that sophisticated investors are capable of protecting their 

own interests and do not require the basic protections of the regulated market. That 

myth has been dispelled by the current crisis. Not only did ‘‘sophisticated’’ institutional investors load up on toxic mortgage-backed securities and collateralized debt 

obligations without understanding the risks of those investments, but financial institutions themselves either didn’t understand or chose to ignore the risks they were 

exposing themselves to when they bought toxic assets with borrowed money or funded long-term obligations with short-term financing. By failing to protect their own 

interests, they damaged not only themselves and their shareholders, but also the 

financial markets and the global economy as a whole. This situation simply cannot 

be allowed to continue. Any proposal to address systemic risk must confront this 

issue head-on in order to be credible. 

Other Risk-Related Priorities Should Also Be Addressed 

There are other pressing regulatory issues that, while not expressly classified as 

systemic risk, are directly relevant to any discussion of how best to reduce systemic 

risk. Chairman Frank has appropriately raised the issue of executive compensation 

in this context, and CFA supports efforts to reduce compensation incentives that 

promote excessive risk-taking. 

Similarly, improving the reliability of credit ratings while simultaneously reducing our reliance on those ratings is a necessary component of any comprehensive 

plan to reduce systemic risk. Ideally, some mechanism will be found to reduce the 

conflicts of interest associated with the agencies’ issuer-paid compensation model. 

Whether or not that is the case, we believe credit rating agencies must face increased accountability for their ratings, the SEC must have increased authority to 

police their ratings activities to ensure that they follow appropriate due diligence 

standards in arriving at and maintaining those ratings, and laws and rules that reference the ratings must make clear that reliance on ratings alone does not satisfy 

due diligence obligations to ensure the appropriateness of the investment. 

In addition, CFA believes one of the most important lessons that have been 

learned regarding the collapse of our financial system is that improved, up-front 

product-focused regulation will significantly reduce systemic risk. For example, if 

federal regulators had acted more quickly to prevent abusive sub-prime mortgage 

loans from flooding the market, it is likely that the current housing and economic 

crisis would not have been triggered. As a result, we have endorsed the concept advanced by COP Chair Elizabeth Warren and legislation introduced by Senator Richard Durbin and Representative William Delahunt to create an independent financial 

safety commission to ensure that financial products meet basic standards of consumer protection. Some opponents of this proposal have argued that it would stifle 

innovation. However, given the damage that recent ‘‘innovations’’ such as liar’s 

loans and Mezzanine CDOs have done to the global economy, this hardly seems like 

a compelling argument. By distinguishing between beneficial and harmful innovations, such an approach could in our view play a key role in reducing systemic risks. 

Congress Needs To Enhance the Quality of Systemic Risk Oversight 

In addition to addressing those issues that currently create a significant potential 

for systemic risk, Congress also needs to enhance the quality of systemic risk oversight going forward. Financial Services Roundtable Chief Executive and CEO Steve 

Bartlett summed up the problem well in earlier testimony before the Senate Banking Committee when he said that the recent crisis had revealed that our regulatory 
210 

system ‘‘does not provide for sufficient coordination and cooperation among regulators, and that it does not adequately monitor the potential for market failures, 

high-risk activities, or vulnerable interconnections between firms and markets that 

can create systemic risk.’’ 

In keeping with that diagnosis of the problem, CFA believes the goals of systemic 

risk regulation should be: (1) to ensure that risks that could threaten the broader 

financial system are identified and addressed; (2) to reduce the likelihood that a 

‘‘systemically significant’’ institution will fail; (3) to strengthen the ability of regulators to take corrective actions before a crisis to prevent imminent failure; and (4) 

to provide for the orderly failure of nonbank financial institutions. The latter point 

deserves emphasis, because this appears to be a common misconception: the goal of 

systemic risk regulation is not to protect certain ‘‘systemically significant’’ institutions from failure, but rather to simultaneously reduce the likelihood of such a failure and ensure that, should it occur, there is a mechanism in place to allow that 

to happen with the minimum possible disruption to the broader financial markets. 

Although there appears to be near universal agreement about the need to improve 

systemic risk regulation, strong disagreements remain over the best way to accomplish that goal. The remainder of this testimony will address those key questions 

regarding such issues as who should regulate for systemic risk, who should be regulated, what that regulation should consist of, and how it should be funded. CFA has 

not yet reached firm conclusions on all of these issues, including on the central 

question of how systemic risk regulation should be structured. Where our position 

remains unresolved, we will discuss possible alternatives and the key issues we believe need to be resolved in order to arrive at a conclusion. 

Should There Be a Central Systemic Risk Regulator? 

As discussed above, we believe all financial regulators should bear a responsibility 

to monitor for and mitigate potential systemic risks. Moreover, we believe a regulatory approach that both closes regulatory loopholes and reinvigorates traditional 

regulation for solvency and consumer and investor protection would go a long way 

toward accomplishing that goal. Nonetheless, we agree with those who argue that 

there is a benefit to having some central authority responsible and accountable for 

overseeing these efforts, if only to coordinate regulatory efforts related to systemic 

risk and to ensure that this remains a priority once the current crisis is past. 

Perhaps the best reason to have one central authority responsible for monitoring 

systemic risk is that, properly implemented, such an approach offers the best assurance that financial institutions will not be able to exploit newly created gaps in the 

regulatory structure. Financial institutions have devoted enormous energy and creativity over the past several decades to finding, maintaining, and exploiting gaps 

in the regulatory structure. Even if Congress does all that we have urged to close 

the regulatory gaps that now exist, past experience suggests that financial institutions will immediately set out to find new ways to evade legal restrictions. 

A central systemic risk regulatory authority could and should be given responsibility for quickly identifying any such activities and assigning them to their appropriate place within the regulatory system. Without such a central authority, regulators may miss activity that does not explicitly fall within their jurisdiction or disputes may arise over which regulator has authority to act. CFA believes designating 

a central authority responsible for systemic risk regulation offers the best hope of 

quickly identifying and addressing new risks that emerge that would otherwise be 

beyond the reach of existing regulations. 

Who Should It Be? 

Resolving who should regulate seems to be the most vexing problem in designing 

a system for improved systemic risk regulation. Three basic proposals have been put 

forward: (1) assign responsibility for systemic risk regulation to the Fed; (2) create 

a new market stability regulator; and (3) expand the President’s Working Group on 

Financial Markets (PWG) and give it an explicit mandate to coordinate and oversee 

regulatory efforts to monitor and mitigate systemic threats. Each approach has its 

flaws, and it is far easier to poke holes in the various proposals than it is to design 

a fool-proof system for improving risk regulation. 

The Federal Reserve Board—Many people believe the Federal Reserve Board (the 

‘‘Fed’’) is the most logical body to serve as systemic risk overseer. Those who favor 

this approach argue that the Fed has the appropriate mission and expertise, an experienced staff, a long tradition of independence, and the necessary tools to serve 

in this capacity (e.g., the ability to act as lender of last resort and to provide emergency financial assistance during a financial crisis). Robert C. Pozen summed up 

this viewpoint succinctly when he testified before the Senate Committee on Homeland Security and Governmental Affairs. He said: 
211 

Congress should give this role to the Federal Reserve Board because it has 

the job of bailing out financial institutions whose failure would threaten the 

whole financial system . . . If the Federal Reserve Board is going to bail 

out a broad array of financial institutions, and not just banks, it should 

have the power to monitor systemic risks so it can help keep institutions 

from getting to the brink of failure. 

Two other, more pragmatic arguments have been cited in favor of giving these responsibilities to the Fed: (1) its ability to obtain adequate resources without relying 

on the congressional budget process and (2) the relative speed and ease with which 

this expansion of authority could be accomplished, particularly in comparison with 

the challenges of establishing a new agency for this purpose. 

Others are equally convinced that the Fed is the last agency that should be entrusted with responsibility for systemic risk regulation. Some cite concerns about 

conflicts inherent in the governance role bank holding companies play in the regional Federal Reserve Banks. Particularly when combined with the Board’s closed 

culture and lack of public accountability, this conflict is seen as likely to undermine 

public trust in the objectivity of agency decisions about which institutions will be 

bailed out and which will be allowed to fail in a crisis. Opponents of the Fed as systemic risk regulator also cite a conflict between its role setting monetary policy and 

its potential role as a systemic risk regulator. One concern is that its role in setting 

monetary policy requires freedom from political interference, while its role as systemic risk regulator would require full transparency and public accountability. Another involves the question of how the Fed as systemic risk regulator would deal 

with the Fed as central banker if its monetary policy was contributing to systemic 

risk (as it clearly did in the run-up to the current crisis). 

Others simply point to what they see as the Fed’s long history of regulatory failure. This includes not only failures directly related to the current crisis—its failure 

to address unsound mortgage lending on a timely basis, for example, as well as its 

failure to prevent banks from holding risky assets in off-balance-sheet special purpose entities and its cheerleading of the rapid expansion of the shadow banking system—but also a perceived past willingness at the Fed to allow banks to hide their 

losses. According to this argument, Congress ultimately passed FDICIA in 1991 (requiring regulators to close financial institutions before all the capital or equity has 

been depleted) precisely because the Fed had been unwilling to do so absent that 

requirement. 

Should Congress determine to give systemic risk responsibility to the Fed, we believe it is essential that you take meaningful steps to address what we believe are 

compelling concerns about this approach. Even some who have spoken in favor of 

the Fed in this capacity have acknowledged that it will require significant restructuring. As former Federal Reserve Chairman Paul Volcker noted in remarks before 

the Economic Club of New York last April: 

If the Federal Reserve is also . . . to have clear authority to carry effective 

‘umbrella’ oversight of the financial system, internal reorganization will be 

essential. Fostering the safety and stability of the financial system would 

be a heavy responsibility paralleling that of monetary policy itself. Providing direction and continuity will require clear lines of accountability . . . 

all backed by a stronger, larger, highly experienced and reasonably compensated professional staff. 

CFA concurs that, if systemic risk regulation is to be housed at the Fed, systemic 

risk regulation must not be relegated to Cinderella status within the agency. Rather, it must be given a high priority within the organization, and significant additional staff dedicated to this task must be hired who have specific risk assessment 

expertise. Serious thought must also be given to (1) how to resolve disputes between 

these two potentially competing functions of setting monetary policy and mitigating 

systemic risks, and (2) how to ensure that systemic risk regulation is carried out 

with the full transparency and public accountability that it demands. 

A New Systemic Risk Regulatory Agency—Some have advocated creation of an entirely new regulatory agency devoted to systemic risk regulation. The idea behind 

this approach is that it would allow a singular focus on issues of systemic risk, both 

providing clear accountability and allowing the hiring of specialized staff devoted to 

this task. Furthermore, such an agency could be structured to avoid the significant 

concerns associated with designating the Fed to perform this function, including the 

conflict between monetary policy and systemic risk regulation. 

Although it has its advocates, this approach appears to trigger neither the broad 

support nor the impassioned opposition that the Fed proposal engenders. Those who 

favor this approach, including Brookings scholar Robert Litan, tend to do so only 
212 

if it is part of a more radical regulatory restructuring. Adding such an agency to 

the existing regulatory structure would ‘‘add still another cook to the regulatory 

kitchen, one that is already too crowded, and thus aggravate current jurisdictional 

frictions,’’ Litan said in recent testimony before the Senate Committee on Homeland 

Security and Governmental Operations. Moreover, even its advocates tend to acknowledge that it would be a challenge, and possibly an insurmountable challenge, 

to get such an agency up and running in a timely fashion. 

Expanded and Refocused President’s Working Group—The other approach that enjoys significant support entails giving an expanded version of the President’s Working Group for Financial Markets clear, statutory authority for systemic risk oversight. Its current membership would be expanded to include all the major federal 

financial regulators as well as representatives of state securities, insurance, and 

banking officials. By formalizing the PWG’s authority through legislation, the group 

would be directly accountable to Congress, allowing for meaningful congressional 

oversight. 

Among the key benefits of this approach: the council would have access to extensive information about and expertise in all aspects of financial markets. The regulatory bodies with primary day-to-day oversight responsibility would have a direct 

stake in the panel and its activities, maximizing the chance that they would be fully 

cooperative with its efforts. For those who believe the Fed must play a significant 

role in systemic risk regulation, this approach offers the benefit of extensive Fed involvement as a member of the PWG without the problems associated with exclusive 

Fed oversight of systemic risk. 

This approach, while offering attractive benefits, is not without its shortcomings. 

One is the absence of any single party who is solely accountable for regulatory efforts to mitigate systemic risks. Because it would have to act primarily through its 

member bodies, it could result in an inconsistent and even conflicting approach 

among regulators. It also raises the risk that systemic risk regulation will not be 

given adequate priority. In dismissing this approach, Litan acknowledges that it 

may be the most politically feasible but he maintains: ‘‘A college of regulators clearly violates the Buck Stops Here principle, and is a clear recipe for jurisdictional battles and after-the-fact finger pointing.’’ 

Despite the many attractions of this approach, this latter point is particularly 

compelling, in our view. Regulators have a long history of jurisdictional disputes. 

There is no reason to believe those problems would simply dissipate under this arrangement. Decisions about who has responsibility for newly emerging activities 

would likely be particularly contentious. If Congress were to decide to adopt this approach, it would need to set out some clear mechanism for resolving any such disputes. Alternatively, it could combine this approach with enhanced systemic risk authority for either the Fed or a new agency, as the Financial Services Roundtable 

has suggested, providing that agency with the benefit of the panel’s broad expertise 

and improving coordination of regulatory efforts in this area. 

FDIC—A major reason federal authorities were forced to improvise in managing 

the events of the past year is that we lack a mechanism for the orderly unwinding 

of nonbank financial institutions that is comparable to the authority that the FDIC 

has for banks. Most systemic risk plans seem to contemplate expanding FDIC authority to include nonbank financial institutions, although some would house this 

authority within a systemic risk regulator. CFA believes this is an essential component of a comprehensive plan for enhanced systemic risk regulation. While we have 

not worked out exactly how this should operate, we believe the FDIC, the systemic 

risk regulator, or the two agencies working together must also have authority to intervene when failure appears imminent to require corrective actions. 

A Systemic Risk Advisory Panel—One of the key criticisms of making the Fed the 

systemic risk regulator is its dismal regulatory record. But if we limited our selections to those regulators with a credible record of identifying and addressing potential systemic risks while they are still at a manageable stage, we’d be forced to start 

from scratch in designing a new regulatory body. And there is no guarantee we 

would get it right this time. 

A number of academics and others outside the regulatory system were far ahead 

of the regulators in recognizing the risks associated with unsound mortgage lending, 

unreliable ratings on mortgage-backed securities and CDOs, the build-up of excessive leverage, the questionable risk management practices of investment banks, etc. 

Regardless of what approach Congress chooses to adopt for systemic risk oversight, 

we believe it should also mandate creation of a high-level advisory panel on systemic risk. Such a panel could include academics and other analysts from a variety 

of disciplines with a reputation for independent thinking and, preferably, a record 

of identifying weaknesses in the financial system. Names such as Nouriel Roubini, 
213 

Frank Partnoy, Joseph Mason, and Joshua Rosner immediately come to mind as attractive candidates for such a panel. 

The panel would be charged with conducting an on-going and independent assessment of systemic risks to supplement the efforts of the regulators. It would report 

periodically to both Congress and the regulatory agencies on its findings. It could 

be given privileged access to information gathered by the regulators to use in making its assessment. When appropriate, it might recommend either legislative or regulatory changes with a goal of reducing risks to the financial system. CFA believes 

such an approach would greatly enhance the accountability of regulators and reduce 

the risks of group-think and complacency. We urge you to include this as a component of your regulatory reform plan. 

Who Should Be Regulated? 

The debate over who should be regulated for systemic risk basically boils down 

to two main points of view. Those who see systemic risk regulation as something 

that kicks in during or on the brink of a crisis, to deal with the potential failure 

of one or more financial institutions, tend to favor a narrower approach focused on 

a few large or otherwise ‘‘systemically important’’ institutions. In contrast, those 

who see systemic risk regulation as something that is designed, first and foremost, 

to prevent risks from reaching that degree of severity tend to favor a much more 

expansive approach. Recognizing that systemic risk can derive from a variety of different practices, proponents of this view argue that all forms of financial activity 

must be subject to systemic risk regulation and that the systemic risk regulator 

must have significant flexibility and authority to determine the extent of its reach. 

CFA falls firmly into the latter camp. We are not alone; this expansive view of 

systemic risk jurisdiction has many supporters, at least when it comes to the regulator’s authority to monitor the markets for systemic risk. The Government Accountability Office, for example, has said that such efforts ‘‘should cover all activities that 

pose risks or are otherwise important to meeting regulatory goals.’’ Bartlett of the 

Financial Services Roundtable summed it up well in his testimony when he said 

that: 

authority to collect information should apply not only to depository institutions, but also to all types of financial services firms, including broker/dealers, insurance companies, hedge funds, private equity firms, industrial loan 

companies, credit unions, and any other financial services firms that facilitate financial flows (e.g., transactions, savings, investments, credit, and financial protection) in our economy. Also, this authority should not be based 

upon the size of an institution. It is possible that a number of smaller institutions could be engaged in activities that collectively pose a systemic risk. 

The case for giving a systemic risk regulator broad authority to monitor the markets 

for systemic risk is obvious, in our opinion. Failure to grant a regulator this broad 

authority risks allowing risks to grow up outside the clear jurisdiction of functional 

regulators, a situation financial institutions have shown themselves to be very creative at exploiting. 

While the case for allowing the systemic risk regulator broad authority to monitor 

the financial system as a whole seems obvious, the issue of whether to also grant 

that regulator authority to constrain risky conduct wherever they find it is more 

complex. Those who favor a narrower approach argue that the proper focus of any 

such regulatory authority should be limited to those institutions whose failure 

would be likely to create a systemic risk. This view is based on the sentiment that, 

if an institution is too big to fail, it must be regulated. While CFA shares the view 

that those firms that are ‘‘too big to fail’’ must be regulated, we take that view one 

step further. As we have discussed above, we believe that the best way to reduce 

systemic risk is to ensure that all financial activity is regulated to ensure that it 

is conducted according to basic principles of transparency, fair dealing, and accountability. 

Those like Litan who favor a narrower approach focused on ‘‘systemically important’’ institutions defend it against charges that it creates unacceptable moral hazard by arguing that it is essentially impossible to expand on the moral hazard that 

has already been created by recent federal bailouts simply by formally designating 

certain institutions as systemically significant. We agree that, based on recent 

events and unless the approach to systemic risk is changed, the market will assume 

that large firms will be rescued, just as the market rightly assumed for years, despite assurances to the contrary, that the government would stand behind the 

GSEs. Nonetheless, we do not believe it follows that the appropriate approach to 

systemic risk regulation is to focus exclusively on these institutions that are most 

likely to receive a bailout. Instead, we believe it is essential to attack risks more 
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broadly, before institutions are threatened with failure and, to the degree possible, 

to eliminate the perception that large institutions will always be rescued. The latter 

goal could be addressed both by reducing the practices that make institutions systemically significant and by creating a mechanism to allow their orderly failure. 

Ultimately, we believe a regulatory approach that relies on identifying institutions 

in advance that are systemically significant is simply unworkable. The fallibility of 

this approach was demonstrated conclusively in the wake of the government’s determination that Lehman Brothers, unlike Bear Stearns, was not too big to fail. As 

Richard Baker, President and CEO of the Managed Funds Association, said in his 

testimony before the House Capital Markets Subcommittee, ‘‘There likely are entities that would be deemed systemically relevant . . . whose failure would not 

threaten the broader financial system.’’ We also agree with NAIC Chief Executive 

Officer Therese Vaughn, who said in testimony at the same hearing, ‘‘In our view, 

an entity poses systemic risk when that entity’s activities have the ability to ripple 

through the broader financial system and trigger problems for other counterparties, 

such that extraordinary action is necessary to mitigate it.’’ 

The factors that might make an institution systemically important are complex— 

going well beyond asset size and even degree of leverage to include such considerations as nature and degree of interconnectivity to other financial institutions, risks 

of activities engaged in, nature of compensation practices, and degree of concentration of financial assets and activities, to name just a few. Trying to determine in 

advance where that risk is likely to arise would be all but impossible. And trying 

to maintain an accurate list of systemically important institutions going forward, 

considering the complex array of factors that are relevant to that determination, 

would require constant and detailed monitoring of institutions on the borderline, 

would be extremely time-consuming, and ultimately would almost certainly allow 

certain risky institutions and practices to fall through the cracks. 

How Should They Regulate? 

There are three key issues that must be addressed in determining the appropriate 

procedures for regulating to mitigate systemic risk: 

• Should responsibility and authority to regulate for systemic risks kick in only 

in a crisis, or on the brink of a crisis, or should it be an on-going, day-to-day 

obligation of financial regulators? 

• What regulatory tools should be available to a systemic risk regulator? For example, should a designated systemic risk regulator have authority to take corrective actions, or should it be required (or encouraged) to work through functional regulators? 

• If a designated systemic risk regulator has authority to require corrective actions, should it apply generally to all financial institutions, products, and practices or should it be limited to a select population of systemically important institutions? 

When the Treasury Department issued its Blueprint for regulatory reform a year 

ago, it proposed to give the Federal Reserve broad new authority to regulate systemic risk but only in a crisis. Despite the sweeping scope of its restructuring proposals, Treasury clearly envisioned a strictly limited role within systemic risk regulation for regulatory interventions exercised primarily through its role as lender of 

last resort. Although there are a few who continue to advocate a version of that 

viewpoint, we believe events since the Blueprint’s release have conclusively proven 

the disadvantages of this approach. As Volcker stated in his New York Economic 

Club speech: ‘‘I do not see how that responsibility can be turned on only at times 

of turmoil—in effect when the horse has left the barn.’’ We share that skepticism, 

convinced like the authors of the COP Report that, ‘‘Systemic risk needs to be managed before moments of crisis, by regulators who have clear authority and the proper tools.’’ 

As noted above, most parties appear to agree that a systemic risk regulator must 

have broad authority to survey all areas of financial markets and the flexibility to 

respond to emerging areas of potential risk. CFA shares this view, believing it 

would be both impractical and dangerous to require the regulator to go back to Congress each time it sought to extend its jurisdiction in response to changing market 

conditions. Others have described a robust set of additional tools that regulators 

should have to minimize systemic risks. As the Group of 30 noted in its report on 

regulatory reform: ‘‘ . . . a legal regime should be established to provide regulators 

with authority to require early warnings, prompt corrective actions, and orderly 

closings’’ of certain financial institutions. The specific regulatory powers various parties have recommended as part of a comprehensive framework for systemic risk regulation include authority to: 
215 

• Set capital, liquidity, and other regulatory requirements directly related to risk 

management; 

• Require firms to pay some form of premium, much like the premiums banks pay 

to support the federal deposit insurance fund, adjusted to reflect the bank’s size, 

leverage, and concentration, as well as the risks associated with its activities; 

• Directly supervise at least certain institutions; 

• Act as lender of last resort with regard to institutions at risk of failure; 

• Act as a receiver or conservator of a failed nondepository organization and to 

place the organization in liquidation or take action to restore it to a sound and 

solvent condition; 

• Require corrective actions at troubled institutions that are similar to those provided for in FDICIA; 

• Make regular reports to Congress; and 

• Take enforcement actions, with powers similar to what Federal Reserve currently has over bank holding companies. 

Without evaluating each recommendation individually or in detail, CFA believes 

this presents an appropriately comprehensive view of the tools necessary for systemic risk regulation. 

Most of those who have commented on this topic would give at least some of this 

responsibility and authority—such as demanding corrective actions to reduce risks— 

directly to a systemic risk regulator. Others would require in all but the most extreme circumstances that a systemic risk regulator exercise this authority only in 

cooperation with functional regulators. Both approaches have advantages and disadvantages. Giving a systemic risk regulator this authority would ensure consistent 

application of standards and establish a clear line of accountability for decisionmaking in this area. But it would also demand, perhaps unrealistically, that the 

regulator have a detailed understanding of how those standards would best be implemented in a vast variety of firms and situations. Relying on functional regulators 

to act avoids the latter problem but sets up a potential for jurisdictional conflicts 

as well as inconsistent and delayed implementation. If Congress decides to adopt 

the latter approach, it will need to make absolutely clear what authority the systemic risk regulator has to require its regulatory partners to take appropriate action. Without that clarification, disputes over jurisdiction are inevitable, and inconsistencies and conflicts are bound to emerge. It would also be doubly important 

under such an approach to ensure that gaps in the regulatory framework are closed 

and that all regulators share a responsibility for reducing systemic risk. 

Many of those who would give a systemic risk regulator this direct authority to 

demand corrective actions would limit its application to a select population of systemically important institutions. The Securities Industry and Financial Markets Association has advocated, for example, that the resolution system for nonbank firms 

apply only to ‘‘the few organizations whose failure might reasonably be considered 

to pose a threat to the financial system.’’ In testimony before the House Capital 

Markets Subcommittee, SIFMA President and CEO T. Timothy Ryan, Jr. also suggested that the systemic risk regulator should only directly supervise systemically 

important financial institutions. 

Such an approach requires a systemic risk regulator to identify in advance those 

institutions that pose a systemic risk. Others express strong opposition to this approach. As former Congressman Baker of the MFA said in his recent House Subcommittee testimony: 

An entity that is perceived by the market to have a government guarantee, 

whether explicit or implicit, has an unfair competitive advantage over other 

market participants. We strongly believe that the systemic risk regulator 

should implement its authority in a way that avoids this possibility and 

also avoids the moral hazards that can result from a company having an 

ongoing government guarantee against failure. 

Unfortunately, the recent actions the government was called on to take to rescue 

a series of nonbank financial institutions has already created that implied backing. 

Simply refraining from designating certain institutions as systemically significant 

will not be sufficient to dispel that expectation, and it would at least provide the 

opportunity to subject those firms to tougher standards and enhanced oversight. As 

discussed above, however, CFA believes this approach to be unworkable. 

That is a key reason why we believe it is absolutely essential to provide for corrective action and resolution authority as part of a comprehensive plan for enhanced 

systemic risk regulation. As money manager Jonathan Tiemann argued in a recent 

article entitled ‘‘The Wall Street Vortex’’: 
216 

Some institutions are so large that their failure would imperil the financial 

system. As such, they enjoy an implicit guarantee, which could . . . force 

us to nationalize their losses. But we need for all financial firms that run 

the risk of failure to be able to do so without causing a widespread financial 

meltdown. The most interesting part of the debate should be on this point, 

whether we could break these firms into smaller pieces, limit their activities, or find a way to compartmentalize the risks that their various business 

units take. 

CFA believes this is an issue that deserves more attention than it has garnered 

to date. One option is to try to maximize the incentives of private parties to avoid 

risks, for example by subjecting financial institutions to risk-based capital requirements and premium payments. To serve as a significant deterrent to risk, these requirements would have to ratchet up dramatically as institutions grew in size, took 

on risky assets, increased their level of leverage, or engaged in other activities 

deemed risky by regulators. It has been suggested, for example, that the Fed could 

have prevented the rapid growth in use of over-the-counter credit default swaps by 

financial institutions if it had adopted this approach. It could, for example, have imposed capital standards for use of OTC derivatives that were higher than the margin requirements associated with trading the same types of derivatives on a clearinghouse and designed to reflect the added risks associated with trading in the overthe-counter markets. In order to minimize the chances that institutions will avoid 

becoming too big or too inter-connected to fail, CFA urges you to include such incentives as a central component of your systemic risk regulation legislation. 

Conclusion 

Decades of Wall Street excess unchecked by reasonable and prudential regulation 

have left our markets vulnerable to systemic shock. The United States, and indeed 

the world, is still reeling from the effects of the latest and most severe of a long 

series of financial crises. Only a fundamental change in regulatory approach will 

turn this situation around. While structural changes are a part of that solution, 

they are by no means the most important aspect. Rather, returning to a regulatory 

approach that recognizes both the disastrous consequences of allowing markets to 

self-regulate and the necessity of strong and effective governmental controls to rein 

in excesses is absolutely essential to achieving this goal. 

PREPARED STATEMENT OF DAVID G. TITTSWORTH 

EXECUTIVE DIRECTOR AND EXECUTIVE VICE PRESIDENT, 

INVESTMENT ADVISER ASSOCIATION

MARCH 26, 2009 

EXECUTIVE SUMMARY

Profile of Investment Advisory Profession. There are about 11,000 SEC-registered 

investment advisers. These firms collectively provide investment management and 

other advisory services to a wide range of clients, including individuals, trusts, and 

families, as well as institutional clients, such as endowments, foundations, charitable institutions, state and local governments, pension funds, corporations, mutual 

funds, and hedge funds. There are relatively few large firms in the investment advisory profession, but they manage the lion’s share of total assets. Most investment 

advisers are small businesses. About 7,500 employ 10 or fewer employees and 90 

percent employ fewer than 50 people. 

Principles for Regulatory Reform. Restoring the vitality of the U.S. economy, renewing investor confidence, and addressing failures of and weaknesses in the current regulatory framework are clearly the highest priority for this Committee. To 

that end, the IAA offers the following principles for the Committee’s consideration: 

• First, the IAA supports the efforts of the Congress, the Administration, regulators, and others to address the root causes of the economic crisis, including 

subprime mortgages, securitization of mortgage-related instruments, and the 

degree to which leverage contributed to the crisis. 

• Second, systemic risk oversight must be strengthened. Such oversight should 

complement but not replace robust functional regulation of financial institutions. In that vein, Congress must preserve and adequately fund the Securities 

and Exchange Commission’s core missions of protecting investors, maintaining 

fair and orderly markets, and facilitating capital formation. 
217 

• Third, we believe Congress and regulators must address the true regulatory 

gaps that exist in our current system. Any systemic risk initiatives are destined 

for failure until and unless these gaps are addressed. 

• The IAA continues to support centralized registration and regulation of hedge 

fund managers by the SEC. Investors, the marketplace, and regulators will 

benefit from the disclosure, compliance protocols, recordkeeping, exams, and 

other requirements that accompany SEC registration and regulation of hedge 

fund managers. 

• We also support stronger oversight and transparency of credit default swaps 

and other complex financial derivatives. The role of these products in the economic crisis has been demonstrated all too clearly. Action must be taken to 

ensure that these products can no longer be traded outside of a regulatory 

system that promotes transparency and accountability. 

• The IAA supports efforts to provide greater regulatory oversight of credit rating agencies. Congress should address conflicts of interest inherent in the rating agencies’ compensation structures and bring greater transparency to the 

process. 

• Congress should consider enhancing investor protection by applying the core 

principles of the Investment Advisers Act of l940 as integral elements of a regulatory framework for other financial service providers. 

Investment Adviser Issues. In the current debate, two issues have been raised that 

directly implicate the Investment Advisers Act, the law governing investment advisory firms. 

• Testimony before this Committee has raised the concept of ‘‘harmonizing’’ laws 

and regulations governing brokers and investment advisers, including proposals 

to replace an investment adviser’s fiduciary duty with some other standard. The 

IAA agrees that market and regulatory developments—primarily the migration 

of brokers toward more traditional advisory services—has created investor confusion about the respective roles and obligations of brokers, advisers, and others 

who provide investment advice. But we disagree that extending the sale-of-products structure governing brokers would be appropriate for investment advisers 

providing professional services. Instead, we believe any ‘‘harmonization’’ of laws 

and regulations governing brokers and investment advisers should extend the 

investor protection benefits of investment adviser fiduciary standards to anyone 

who offers investment advice. Fiduciary duty requires firms to act in the best 

interest of their clients and to place client interests ahead of their own. Other 

standards may require only a commercial duty of fair dealing in arm’s-length 

transactions. Such standards are not commensurate with the trust and confidence placed by investors in their financial services professional. Earlier this 

week, our organization joined the North American Securities Administrators Association and the Consumer Federation of America in a joint letter to this Committee that underscores the need to apply fiduciary standards to all who provide 

investment advice. 

• The idea of establishing a self-regulatory organization (SRO) for investment advisers has been raised and rejected a number of times over the years. We continue to oppose the creation of an SRO for the advisory profession. The drawbacks to an SRO—including inherent conflicts of interest, questions about 

transparency, accountability, and oversight, and added costs and bureaucracy— 

continue to outweigh any alleged benefits. We particularly oppose the idea of 

FINRA as the SRO for investment advisers, given its governance structure, 

costs, track record, and advocacy of the broker-dealer model of regulation. 

• We believe the SEC has the necessary expertise and experience to govern the 

activities of the investment advisory profession. However, the adequacy of the 

SEC’s resources to exercise proper oversight of investment advisers is a legitimate question that deserves serious attention by policy makers. Instead of focusing on an SRO as the response to this question, Congress and the SEC 

should take steps to bolster the SEC’s resources: 

• There must be full funding for the SEC’s regulatory, inspection, and enforcement efforts. We believe Congress should examine alternatives to allow the 

agency to achieve longer-term and more stable funding, including self-funding 

mechanisms. 

• The SEC should increase the $25 million threshold that separates federally 

registered and state-registered advisers. An increase in the threshold would 

reduce the number of SEC-registered advisers and permit the SEC to focus 
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1The Investment Adviser Association (IAA) is a not-for-profit trade association that exclusively represents the interests of federally registered investment advisory firms. Founded in 

1937 as the Investment Counsel Association of America (ICAA), the IAA’s membership consists 

of investment advisory firms that provide investment advice to a wide variety of clients, including individuals, trusts, endowments, foundations, corporations, pension funds, mutual funds, 

state and local governments, and hedge funds. For more information, please see 

www.investmentadviser.org. 

on the appropriate universe of advisers on a risk-adjusted basis in its examination program. 

• The SEC can and should improve its inspection program for investment advisers. There are a number of steps the SEC can take to better leverage its 

resources with respect to examinations. For example, the SEC should consider 

revamping its inspection program to focus more on finding fraud as opposed 

to technical rules violations. Better technology, enhanced training, and additional data could assist in these efforts as well. We would be pleased to work 

with the Committee and the SEC to explore additional ways to ensure that 

investment advisers are subject to appropriate and timely examinations. 

Introduction 

The Investment Adviser Association (IAA) 1 greatly appreciates the opportunity to 

appear before the Committee today to address significant issues and developments 

relating to enhancing investor protection and the regulation of securities markets. 

The IAA’s members bring important perspectives to the regulatory reform discussion both as entities subject to regulation and as investors in the securities markets 

on behalf of their clients. The continuing economic crisis, as well as recent events 

such as the Madoff scandal, have focused attention on issues relating to how the 

financial services industry is regulated. These developments have prompted a reevaluation of whether current oversight structures should be strengthened and modernized. The crisis provides both regulators and the industry with an opportunity 

to enhance investor protection and establish more effective regulatory oversight. 

The IAA stands ready to assist the Committee in undertaking the critical tasks 

of restoring the vitality of the U.S. economy, renewing investor confidence, and addressing failures of, and weaknesses in, the current regulatory framework. 

I. Regulatory Reform 

Before discussing our views on matters that specifically relate to investment adviser regulation, we wish to emphasize our views regarding broader issues of regulatory reform. 

• The Congress, Administration, regulators, and other policy makers should focus 

their collective attention on the root causes of the economic crisis: subprime 

mortgages, securitization of mortgage-related instruments, and the degree to 

which leverage contributed to the crisis. These issues clearly represent the highest priority for legislative and regulatory action. Indeed, the issues discussed 

below relating to potential changes in investment adviser regulation, while important to investor protection, do not address the underlying causes and related 

regulatory and structural changes that need to be put in place to respond to 

the economic crisis. 

• Systemic risk oversight is long overdue. The present fragmented financial regulatory system does not enable adequate coordination and cooperation among a 

complex network of market participants and regulators and no one regulatory 

body is responsible for monitoring and assessing system-wide risk. While systemic risk oversight must be strengthened, such oversight should not replace robust functional regulation of financial institutions. 

• As part of the review of financial regulatory systems, restructuring certain 

government agencies (such as merging the Commodity Futures Trading Commission into the Securities and Exchange Commission) should be considered 

to ensure more effective regulation, efficiency, and accountability. The SEC is 

the primary regulator charged with the mission of protecting investors. In reforming the current regulatory structure, Congress must preserve and adequately fund the SEC’s core missions of protecting investors, maintaining fair 

and orderly markets, and facilitating capital formation. 

• Congress and regulators should close regulatory gaps and appropriately regulate relatively new services and products that have expanded exponentially over 

the last decade, significantly impacting the financial system. Any systemic risk 

initiatives are destined for failure until and unless these gaps are addressed: 
219 

• Hedge Funds. The IAA continues to support centralized registration and regulation of hedge fund managers by the SEC. The SEC is the appropriate functional regulator for investment advisers to hedge funds and other unregulated 

pooled investment vehicles. We do not agree with suggestions by some that 

hedge funds simply be required to provide information periodically to a systemic risk regulator. Investors and the marketplace will benefit from the disclosure, compliance protocols, recordkeeping, examinations, and other requirements that will accompany SEC registration and regulation of hedge fund 

managers. 

• Derivatives. The IAA supports far stronger oversight and transparency of 

credit default swaps and other complex financial derivatives. These products 

played a significant role in the recent market disruptions. Congress should 

consider ways to regulate securities and economic substitutes for securities in 

a similar fashion. Current efforts to establish central counterparties to clear 

credit default swaps, while laudable, are not sufficient, particularly because 

participation is voluntary. 

• Credit Rating Agencies. The IAA supports efforts to provide greater regulatory 

oversight of credit rating agencies, which have increasingly played an important role in the markets. Congress should address conflicts of interest inherent in the rating agencies’ compensation structures and bring greater transparency to the process. 

• Congress should consider enhancing investor protection by applying the core 

principles of the Investment Advisers Act of l940 as integral elements of a regulatory framework for other financial service providers. 

• The core principles of the Advisers Act are fiduciary duty, which includes the 

duty to place the interests of your client above your own interests at all times, 

coupled with broad antifraud authority and full and fair disclosure obligations 

overseen by a single direct regulator (SEC). Congress should extend the investor protection benefits of investment adviser fiduciary standards to all entities 

that offer investment advice. 

In effecting regulatory reform of the financial services industry, policy makers 

should be mindful of three maxims. First, shuffling boxes (i.e., creating new regulatory authorities or merging or eliminating existing regulators) does not necessarily 

constitute regulatory reform. Effective regulation requires direct and appropriate 

statutory authority, clear and reasonable regulations, and intelligent enforcement. 

Second, policy makers should ‘‘do no harm’’ in addressing regulatory reform. Some 

financial service providers already are appropriately regulated and did not contribute to the current crisis. Where such situations exist, policy makers should not 

attempt to reinvent the wheel or create new and additional regulatory requirements. 

Third, the changes under consideration by this Congress are significant and have 

the potential to dramatically reshape the regulatory landscape for decades. Even in 

this environment, getting it right is much more important than acting in haste. 

II. Investment Advisers Act Issues 

In addition to the regulatory reforms under consideration that directly pertain to 

the ongoing financial crisis, two primary issues have been raised that relate to the 

Investment Advisers Act: 

• The concept of ‘‘harmonizing’’ laws and regulations governing broker-dealers 

and investment advisers, including a brokerage industry proposal to replace an 

investment adviser’s fiduciary duty with a universal ‘‘fair dealing’’ standard. 

• Establishment of a self-regulatory organization (SRO) for investment advisers. 

As we discuss in greater detail below, we believe that any ‘‘harmonization’’ of laws 

and regulations governing broker-dealers and investment advisers should extend the 

investor protection benefits of investment adviser fiduciary standards to anyone who 

offers investment advice. In particular, pursuant to fiduciary duty standards, the obligation to disclose conflicts of interest should apply to all those who provide investment advice. In addition, any ‘‘harmonization’’ should not result in subjecting investment advisers to inappropriate broker-dealer rules, including those of a self-regulatory organization. 

In considering these issues, it is critical to understand the investment advisory 

profession. 

A. Profile of the Investment Adviser Profession 

There are about 11,000 SEC-registered investment advisers, representing a broad 

spectrum of firms. There are a few relatively large firms that oversee the lion’s 

share of assets under management. According to information filed with the SEC, as 
220 

2More than 91 percent of SEC-registered advisory firms manage less than $1 billion in assets. 

See IAA/NRS, Evolution/Revolution: A Profile of the U.S. Investment Advisory Profession (2008), 

available on our Web site, at 3. Further, approximately 43.7 percent (4,820) of all investment 

advisers are not affiliated with any other financial industry entity. Id. at 11. 3 Id. at 8. 4The IAA has been actively involved in discussions and proceedings relating to the potential 

‘‘harmonization’’ of broker and adviser rules for many years. We filed numerous comment letters 

responding to the SEC’s rulemakings (first proposed in 1999) relating to the circumstances 

under which the provision of investment advice by brokers subjects their activities to the Advisers Act. See, e.g., Letter from David G. Tittsworth, Investment Counsel Association of America, 

to Jonathan G. Katz, Secretary, Securities and Exchange Commission (Jan. 12, 2000); Letter 

from David G. Tittsworth, Investment Counsel Association of America, to Jonathan G. Katz, 

Secretary, Securities and Exchange Commission (Feb. 7, 2005). In those rulemakings, the IAA 

supported applying a consistent, functional regulatory approach so that the same rules apply 

to the same activities. We also supported functional regulation with respect to other market participants. See, e.g., Letter from David G. Tittsworth, Investment Counsel Association of America,, to Jonathan G. Katz, Secretary, Securities and Exchange Commission, re: Exemption for 

Thrifts Under the Investment Advisers Act (Dec. 27, 2001). 5The Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure 

(Mar. 2008), at 125–126. 

of April 2008, 82 investment advisory firms (less than .7 percent) had investment 

management authority with respect to more than half of the $38.67 trillion in discretionary assets managed by all SEC-registered advisers. Some of these larger 

firms are affiliated with other investment advisers, banks, broker-dealers, and insurance companies. However, the vast majority of investment advisory firms are 

small, unaffiliated businesses. 2 According to information filed with the SEC, 90 percent of all federally registered investment adviser firms have fewer than 50 employees and 68 percent (more than 7,500 firms) have ten or fewer employees. 3 Firms 

with five or fewer employees make up nearly half (49 percent) of all advisers. 

Investment advisers manage assets for a wide array of individual and institutional investors, including high net worth individuals, educational institutions, endowments, foundations, corporations, pension plans, mutual funds, hedge funds, private equity funds, bank collective trusts, insurance companies, and state and local 

governments. The overwhelming majority of SEC-registered investment advisers 

have discretionary authority to make investment decisions on behalf of their clients, 

consistent with the terms of the advisory contract and any client guidelines. Advisory firms employ a variety of investment strategies on behalf of their clients. Given 

the enormous diversity and complexity among different types of investment adviser 

firms, it is notable that 67 percent of the more than 11,000 investment advisers that 

were federally registered as of April 2008 were not engaged in any business activity 

other than giving investment advice. Only 644 investment advisers (5.8 percent) 

were dually registered as broker-dealers. 

The diverse and small business nature of the investment advisory profession benefits the wide range of investors—both individuals and institutions—seeking investment advice and should be preserved. 

B. ‘‘Harmonization’’ of Investment Adviser and Broker-Dealer Laws and Regulations 

Background. Although the concept of ‘‘harmonization’’ of broker-dealer and investment adviser regulation has been advanced recently, few details have emerged describing what harmonization actually means. 4 The term surfaced last year in the 

Treasury Department’s ‘‘Blueprint for a Modernized Financial Regulatory Structure.’’ Among its ‘‘intermediate-term’’ findings, the Blueprint contains a discussion 

of the ‘‘ongoing debate regarding broker-dealer regulation and investment adviser 

regulation,’’ and states: 

Treasury notes the rapid and continued convergence of the services provided by broker-dealers and investment advisers and the resulting regulatory confusion due to a statutory regime reflecting the brokerage and investment advisory businesses of decades ago. An objective of this report is 

to identify regulatory coverage gaps and inefficiencies. This is one situation 

in which the U.S. regulatory system has failed to adjust to market developments, leading to investor confusion. Accordingly, Treasury recommends 

statutory changes to harmonize the regulation and oversight of broker-dealers and investment advisers offering similar services to retail investors. 5

Despite suggesting statutory harmonization, the Treasury Blueprint did not include 

any specific recommendations about what this might entail. 

The Blueprint followed on the heels of a report commissioned by the SEC that 

examined marketing practices and financial products and services provided to individual investors by broker-dealers and investment advisers and evaluated investor 
221 

6 Investor and Industry Perspectives on Investment Advisers and Broker-Dealers, LRN-RAND 

Center for Corporate Ethics, Law, and Governance (pre-publication copy Dec. 2007). 7SEC v. Capital Gains Research Bureau, 375 U.S. 180 (1963). 8See, e.g., In re: Arleen W. Hughes, Exchange Act Release No. 4048 (Feb. 18, 1948). 9Lemke & Lins, Regulation of Investment Advisers, at 2:33 (2008). 

10The first article of the IAA Standards of Practice, entitled ‘‘Fiduciary Duty and Professional 

Responsibility,’’ provides as follows: ‘‘An investment adviser stands in a special relationship of 

trust and confidence with, and therefore is a fiduciary to, its clients. As a fiduciary, an investment adviser has an affirmative duty of care, loyalty, honesty, and good faith to act in the best 

interests of its clients.’’ The Standards describe some of the parameters of fiduciary duty, available at: http://www.investmentadviser.org/eweb/ 

dynamicpage.aspx?webcode=StandardsPractice. 11Testimony of T. Timothy Ryan, Jr., President and Chief Executive Officer, Securities Industry and Financial Markets Association, Before the U.S. Senate Committee on Banking, Housing 

and Urban Affairs, Hearing on ‘‘Enhancing Investor Protection and the Regulation of the Securities Markets’’ (Mar. 10, 2009) (‘‘March 10 Banking Committee Hearing’’). 

understanding of the differences between investment adviser and broker-dealer 

products, services, duties, and obligations. 6 The so-called RAND report found that 

‘‘trends in the financial service market since the early 1990s have blurred the 

boundaries’’ between broker-dealers and investment advisers and that ‘‘the typical 

retail investor finds it difficult to understand the nature of the business from which 

he or she receives investment advisory or brokerage services.’’ The RAND report did 

not set forth any specific policy recommendations relating to its findings. 

Fiduciary Duty. Consistent with our long-standing support for a functional approach, we believe that brokers, advisers and others should be held to the same high 

standards depending not on the statute under which they are registered, but upon 

the role they are playing. If the service being offered bears the core characteristics 

of investment advisory services from the investor’s perspective, it should be subject 

to the same high standards and duties. That high standard is fiduciary duty. 

Investment advisers are subject to a strict fiduciary duty. This duty has been 

upheld by the U.S. Supreme Court 7 and espoused by the SEC for over half a century. 8 Fiduciary duty is the highest standard of care recognized under the law and 

serves as a bedrock principle of investor protection. This duty is one of the primary 

distinctions between investment advisers and others in the financial services industry. As a fiduciary, ‘‘an investment adviser must at all times act in its clients’ best 

interests, and its conduct will be measured against a higher standard of conduct 

than that used for mere commercial transactions.’’ 9 Fiduciary duty is not susceptible to strict definition or formulaic application but rather is dependent upon facts 

and circumstances. However, certain core principles of an adviser’s fiduciary duty 

have been well-established, as reflected in our organization’s Standards of Practice. 10

There has been some dissent from the view that the highest standard should be 

applied to all those who give investment advice. At a recent hearing before the Senate Banking Committee, the Securities Industry and Financial Markets Association 

(SIFMA), in echoing calls for ‘‘harmonization’’ of investment adviser and brokerdealer regulation, concluded that a different legal standard should be applied: 11

SIFMA recommends the adoption of a ‘‘universal standard of care’’ that 

avoids the use of labels that tend to confuse the investing public, and expresses, in plain English, the fundamental principles of fair dealing that individual investors can expect from all of their financial services providers. 

Such a standard could provide a uniform code of conduct applicable to all 

financial professionals. 

We urge the Committee to consider ways to extend an investment adviser’s fiduciary duty to other financial services professionals who offer investment advice—not 

to eliminate it or water it down with some new ‘‘fair dealing’’ standard. Investors 

deserve nothing less than the fiduciary duty owed to them under the Investment 

Advisers Act. Our views on this important subject are shared by others. Earlier this 

week, the IAA joined the North American Securities Administrators Association and 

the Consumer Federation of America in a joint letter to this Committee that supports the extension of an investment adviser’s fiduciary standard to others that provide advisory services: 

Surely we can all agree that, in the current climate, there must be no 

weakening of investor protections. We therefore urge you to resist the call 

to water down the standards applicable to advisory activities and instead 

to extend application of the fiduciary duty to all those engaged in advisory 

services. 
222 

12See Testimony of Paul Schott Stevens, Investment Company Institute, at p. 13; Testimony 

of Damon A. Silvers, AFL–CIO, at p. 8; Testimony of Mercer E. Bullard, Fund Democracy, at 

p. 38; March 10, Banking Committee Hearing. 13Testimony of Stephen Luparello, Interim Chief Executive Officer, FINRA, before the Senate 

Committee on Banking, Housing, and Urban Affairs, at p. 6–7 (Jan. 27, 2009) (‘‘Luparello Testimony’’) (the solution is ‘‘greater regulatory harmonization—creating a regulatory system that 

gives retail investors the same protections and rights no matter what product they buy,’’ including that for every ‘‘transaction,’’ there be consistent: (1) licensing requirements; (2) advertising 

requirements; (3) ‘‘appropriateness’’ standards for products, and (4) full disclosure for the ‘‘products being sold.’’) (emphasis added). 

A number of witnesses made similar statements at the Committee’s first hearing 

on this subject. 12

Other Harmonization Issues. Other than extending fiduciary duty to other financial services providers, the Committee should scrutinize carefully any further specific ‘‘harmonization’’ proposals. We believe that the basic structure of the Investment Advisers Act—including an overarching fiduciary duty, broad antifraud provisions, and single regulator—provides an appropriate structure best designed to promote investor protection. The duties of a fiduciary are significantly different from 

those involved in commercial transactions, including brokers that sell financial products. 

Many of the differences in the regulations governing brokers and advisers appropriately reflect the different business models and services of brokers and advisers. 

Those calling for harmonization do not appear to recognize these differences. For example, at a recent hearing before the Senate Banking Committee, FINRA testimony 

regarding harmonization focused on products and transactions, rather than professional fiduciary services. 13 Broker-dealer rules have derived from the historic role 

of brokers executing transactions and selling financial products to consumers (thus, 

the brokerage industry is commonly referred to as the ‘‘sell side’’). Investment adviser rules have derived from the historic role of advisers in providing investment 

advisory services to clients, including managing client portfolios (thus, the advisory 

profession is commonly referred to as the ‘‘buy side’’). 

Traditionally, brokers have been compensated by commissions derived from sales 

of securities, and any related financial advice provided was nondiscretionary (i.e., 

requiring customer consent). In contrast, advisers traditionally have been compensated by fees (typically based on assets under management) and have provided 

discretionary advice to clients. In a typical contract for discretionary investment 

management services, the client grants the adviser authority to decide which securities to purchase or sell on its behalf. The client also typically grants the adviser authority to select brokers as appropriate to execute trades for the client’s account. 

The investment adviser is then responsible for determining the overall investment 

strategy for the client or the portion of client assets it is retained to manage, consistent with its fiduciary duty to make decisions in the best interest of the client 

and with any written investment guidelines established by the client. Brokers typically have custody of customer funds and securities, whereas most investment advisers use the services of independent third-party custodians to hold client assets. 

We agree that, in some situations, the lines between traditional brokerage and investment advisory services have been blurred in recent years, primarily as a result 

of the migration of brokers toward more traditional advisory services. Accordingly, 

in adopting business models that include investment advisory services, brokers 

should be subject to the fiduciary advice regulatory structure of the Advisers Act, 

rather than attempting to subject advisers to the inapt product-sales approach of 

the Exchange Act. 

We also agree with the RAND report that the migration of brokers toward more 

traditional advisory services—in combination with their use of misleading titles 

(e.g., financial advisor and financial consultant) and a lack of meaningful enforcement of current rules governing the broker-dealer exemption from the Advisers 

Act—has created investor confusion about the respective roles and obligations of 

brokers, advisers, and others who provide investment advice. It would be a perverse 

result, however, if this confusion leads to a diminution in the duties of financial professionals to their clients. Instead, all financial services firms and their personnel 

should be required to provide clear information at the inception of the relationship 

about the services they provide, the fees they charge, and any conflicts of interest. 

Registered investment advisers already are required to provide such information to 

their clients at or before the time they enter into the advisory relationship. 

Investor Education. Strengthening investor protection by imposing the highest 

standards is only a part of the solution. Educated and informed investors will not 

only reduce confusion regarding types of service providers but can also serve as an 

effective guard against fraudsters seeking to take advantage of their clients. At a 
223 

14 Cutting Through the Confusion: Where To Turn for Help with Your Investments, published 

by the Coalition for Investor Education (IAA, CFA, NASAA, Financial Planning Association, and 

CFA Institute), available at: http://www.investmentadviser.org/eweb/ 

dynamicpage.aspx?webcode=Confused. 15Questions relating to the establishment of a self-regulatory organization for the investment 

advisory profession were raised well before 1989. For example, on June 11, 1962, our organization responded to a series of questions from Milton H. Cohen, Director of the SEC’s Special 

Study of the Securities Markets, which included a question as to whether we would consider 

it desirable in the public interest for our organization to ‘‘obtain official status as an industry 

self-governing body.’’ 16See Letter from David S. Ruder, Chairman, U.S. Securities and Exchange Commission to 

The Honorable Dan Quayle, President of the U.S. Senate. (June 19, 1989). 17 In 1980, there were 5,600 SEC-registered investment advisers. By 1990, the number had 

grown to more than 17,000. When the Investment Advisers Supervision Coordination Act was 

enacted in 1996 (Title III of the National Securities Markets Improvement Act), the number of 

SEC-registered investment advisers was more than 22,500. 18Letter from Charles E. Haldeman, Jr., President, Investment Counsel Association of America, Inc., to Senators Christopher J. Dodd and John Heinz (Sept. 22, 1989). 19Title III, National Securities Markets Improvement Act, Pub. Law No. 104-290. 20The $25 million threshold was intended to provide a bright line test for allocating regulatory responsibility of advisers between the SEC and the states, representing a rough cut between advisers that generally do business in interstate commerce and those that generally have 

more localized practices. The report accompanying the Senate-passed bill notes that the Commission ‘‘may also use its exemptive authority under the bill to raise the $25 million threshold 

higher as it deems appropriate in keeping with the purposes of the Investment Advisers Act.’’ 

S. Rpt. 104-293, p. 5 (June 26, 1996). 

minimum, we believe the SEC and FINRA, as well as financial services firms, 

should do more to assist investors in understanding and assessing differences between various investment services professionals. In 2006, we participated with the 

North American Securities Administrators Association (NASAA), Consumer Federation of America (CFA), and others in publishing a brochure that is designed to help 

educate investors about the differences between investment advisers, brokers, and 

financial planners, the legal duties and standards applicable to each, and questions 

that investors should ask in seeking an investment services professional. Entitled, 

‘‘Cutting Through the Confusion: Where to Turn for Help with Your Investments,’’ 

the brochure is an example of the type of investor education that is necessary to 

assist individuals who seek investment assistance. 14

C. Self-Regulatory Organizations and the Advisory Profession 

Background. The idea of establishing a self-regulatory organization (SRO) for investment advisers is not new; it has been raised and rejected a number of times 

over the years. For example, in 1989, 15 the SEC transmitted a legislative proposal 

to Congress to provide for the establishment of one or more self-regulatory organizations for registered investment advisers. 16 The impetus for the 1989 proposal was 

the growth of registered investment advisers—and corresponding increases in the 

number of advisory clients and assets under management—and the lack of adequate 

SEC resources to conduct effective oversight of the profession. 17 In responding to 

the proposed legislation, our organization supported the goal of more effective oversight of the advisory profession, but strongly opposed the establishment of a selfregulatory organization for investment advisers. As is the case today, we commented 

that the problem is not one of structure, but rather how to better fund inspections, 

and noted that the same increased fees that would fund self-regulations would fund 

needed enhancements to the SEC’s inspection program. 18

The 1989 SRO proposal was not pursued. However, a few years later, Congress 

took action to strengthen oversight of the investment advisory profession. The Investment Advisers Supervision Coordination Act was enacted in 1996. 19 The Coordination Act was the most significant revision of the Investment Advisers Act since 

1940. The law allocated responsibility for investment advisers between the SEC and 

the states, with the SEC regulating larger advisers and the states regulating smaller advisers. 

The IAA strongly supported enactment of the Coordination Act, which prohibits an investment adviser from registering with the SEC unless it has more than $25 

million in assets under management (AUM) 20 or is an adviser to a registered investment company or fits within another exemption. The Coordination Act’s allocation of regulatory responsibility between the SEC and the states enhances investor 

protection, provides for more efficient use of limited regulatory resources, and reduces burdensome, inconsistent, and unnecessary regulatory costs. 

The 2008 Treasury Blueprint also raised the SRO issue by recommending that 

Congress should subject investment advisers to a ‘‘self-regulatory regime similar to 

that of broker-dealers.’’ The Blueprint asserted that ‘‘self-regulation of the invest-
224 

21The Department of the Treasury Blueprint for a Modernized Financial Regulatory Structure (Mar. 2008) at 125–126. 22Letter from Mary L. Schapiro, CEO, FINRA, to the Department of the Treasury re: Review 

by the Treasury Department of the Regulatory Structure Associated with Financial Institutions 

(Dec. 19, 2007), at 5. 23Luparello Testimony, supra note 13 at p. 5. 24 Until September 2006, Madoff was registered only as a broker-dealer. Because his firm received no separate fees for his advisory services, Madoff apparently availed himself of the broad 

exemption under the Advisers Act for broker-dealers whose advisory services are ‘‘solely incidental’’ to their brokerage activities and who do not charge ‘‘special compensation’’ for advice. 

However, on January 31, 2006, full compliance with the new SEC ‘‘Broker-Dealer Rule’’ was required. Among other things, the new Rule (vacated by court decision on March 30, 2007) clarified that discretionary management of clients’ accounts—as provided by Madoff—could not be 

considered ‘‘solely incidental’’ to brokerage activities. Accordingly, Madoff could no longer claim 

an exemption from the Advisers Act on this basis and, reportedly at the direction of the SEC, 

registered as an investment adviser. Even after Madoff dually-registered in September 2006, his 

investment advisory function was not operated though a separate entity. 25Testimony of Professor John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia University Law School, before the Senate Committee on Banking, Housing and Urban Affairs (Jan. 

27, 2009). 26 Instead, the Madoff scandal ‘‘demonstrates the problem of leaving solely to broker regulation the kinds of advisory activities that are clearly in need of investment adviser oversight. The 

SEC has corrected the regulatory gap that allowed brokers who provided discretionary advice 

to avoid advisory regulation. As discussed below, the Commission should take steps to ensure 

that all individualized investment advice is subject to advisory regulation.’’ Testimony of Mercer 

Bullard, President and Founder of Fund Democracy, Inc. and Associate Professor of Law at University of Mississippi School of Law, March 10 Banking Committee Hearing. 

ment advisory industry should enhance investor protection and be more cost-effective than direct SEC regulation.’’ 21 This recommendation presumably was prompted 

by FINRA—the only commenter on the Blueprint to recommend an SRO for advisers. 22 More recently, FINRA has cited the Madoff scandal as further justification 

for its longstanding desire to extend its jurisdiction to investment advisers. 23 This 

argument is misplaced. 

The Madoff Scandal. We share the outrage of the Committee and all investors 

about the Madoff scandal. The Madoff case has raised justifiable concerns about the 

ability of regulators to uncover and prevent fraudulent activities. Such fraudulent 

activities cast a shadow over legitimate enterprises and thus underscore our continued support for effective regulatory, inspection, and enforcement activities to ensure 

investor confidence and protection. 

We believe the Madoff scandal represents a failure of enforcement, not of investment adviser regulation. Bernard Madoff operated his Ponzi scheme for decades 

through Bernard Madoff Investment Securities LLC, a brokerage firm. He only became subject to investment adviser regulation in September 2006 when his firm dually registered with the SEC as an investment adviser. 24 Neither before nor after 

September 2006 were his investment advisory activities ever operated though a subsidiary or any other legal entity separate from his brokerage firm. 

According to information that has been made available thus far, both the SEC and 

FINRA conducted numerous inspections of the Madoff firm over a period of many 

years. This fact alone negates any argument that the failure to uncover Madoff’s 

fraudulent activities was the result of insufficient resources or lack of oversight 

since both the SEC and FINRA (and its predecessor organization NASD) had clear 

authority to inspect all aspects of the Madoff enterprise and used their resources 

to inspect the firm on numerous occasions. Unfortunately, these examinations failed 

to uncover the fraudulent activities of the firm. 

Despite FINRA’s claims to the contrary, FINRA had ample authority to examine 

all aspects of the Madoff firm. Professor John C. Coffee, Jr., a witness at the Committee’s January 27 hearing and a widely acknowledged authority on securities law, 

specifically addressed whether FINRA had jurisdiction to examine all accounts of 

the Madoff firm and definitively concluded that FINRA/NASD had clear and unequivocal authority to do so. 25

We thus find it troublesome that FINRA is using the Madoff scandal as an example of why investment advisers should be subjected to its jurisdiction as a self-regulatory organization. 26 Rather than using Madoff as a pretext to expand its jurisdiction, we urge FINRA to instead take steps—similar to those the SEC is taking— 

to seriously examine why its inspections of Madoff failed to uncover the Ponzi 

scheme and how it can avoid such failures in the future. 

The ‘‘solution’’ to Madoff—solely a broker-dealer for most of its existence—is not 

to create a new regulatory structure for advisers, but to enhance the SEC’s tools 

to prevent and detect fraud. For example, sharing of information between FINRA 

and the SEC—especially with regard to dually registered broker-dealers like 
225 

27Letter from Karen L. Barr, General Counsel, Investment Adviser Association to The Hon. 

Mary L. Schapiro, Chairman, SEC (Mar. 6, 2009) (‘‘IAA Letter’’). The letter is available on our 

web site under ‘‘Publications/News’’ and ‘‘Comments & Statements.’’ 28See SEC’s Request for Quotation for Examination Inspection Review (Feb. 12, 2009), available at: https://www.fbo.gov/download/300/300792fafb8a21b909f4b5e1b9d4c0f4/ 

Amendl3lSECHQ1-09-Q-0125lExaminationlInspectionlReview.pdf. 

Madoff—should be formalized. Further, in recent testimony SEC staff noted that it 

is considering ways to ‘‘strengthen the custody and audit requirements for regulated 

firms.’’ We recently submitted a letter to SEC Chairman Schapiro that sets forth 

a number of recommendations for the Commission to consider in issuing an expected 

proposed rulemaking addressing self-custody issues. 27 The SEC’s Office of Inspector 

General is conducting an investigation relating to the agency’s handling of the 

Madoff case (including issuing a request for proposal to review the SEC’s inspection 

program) 28 and the results of that investigation may provide additional recommendations the agency should consider to detect similar frauds in the future. 

The SEC Is the Appropriate Direct Regulator of Investment Advisers. The IAA 

strongly supports robust and appropriate oversight and regulation of the investment 

advisory profession. We believe the SEC has the necessary expertise and experience 

to govern the activities of the investment advisory profession. Given the great diversity among advisory firms—including a relatively small number of large firms and 

thousands of small businesses—this expertise and experience is critical in regulating and overseeing the profession. 

The SEC has been an effective regulator with a strong enforcement arm in the 

areas of disclosure and fiduciary duty, the bedrock principles underlying investment 

adviser regulation. While the current system of regulation and oversight of investment advisers can and should be improved, adding a new and additional layer of 

bureaucracy and cost on the profession via an SRO will not significantly enhance 

investor protection. 

We therefore continue to oppose the creation of an SRO for the advisory profession. Ultimately, the drawbacks to an SRO continue to outweigh any alleged benefits. These drawbacks include inherent conflicts of interest based on industry funding and influence, questions regarding transparency, accountability and oversight, 

due process issues in disciplinary proceedings, and added cost and bureaucracy. 

While self-regulation may appeal to those who wish to shift taxpayer-funded regulation costs to industry, we also note that appropriate government oversight is required in any SRO structure and thus requires expanded dedication of government 

resources. Further, most investment advisory firms are small businesses with limited resources. The costs of any SRO are borne by the regulated entities and will 

obviously impact all investment advisers, including thousands of small advisory 

firms. Ultimately, those costs may be passed on to investors. It would be more cost 

effective to use the industry’s funds that would be spent on an SRO to bolster the 

SEC’s oversight efforts, for example through a self-funding structure as discussed 

below. 

Further, the reasons that persuaded Congress to authorize the creation of an SRO 

for broker-dealers in 1939—including the high level of interconnectivity between 

broker-dealers as well as highly technical issues related to settlement, execution, 

and reconciliation involving broker-dealer transactions—simply do not exist in the 

investment advisory profession. 

Finally, the diversity of the investment adviser industry makes a rules-based SRO 

model unworkable. There is not sufficient commonality among the various types of 

adviser business models—traditional asset management firms, financial planners, 

wealth managers, advisers that are part of global financial institutions, small advisers with a limited number of high net worth clients, advisers that sell products, 

asset allocators, hedge fund managers, mutual fund managers, pension consultants, 

and others—to achieve fair and flexible self-regulation. Command-and-control requirements that seek to impose a one-size-fits-all solution for various legal and regulatory issues do not lend themselves to this widely divergent community of advisers. We thus believe that continued oversight of the advisory profession by the SEC 

under the current structure of the Advisers Act—and its reliance on disclosure and 

broad antifraud authority rather than specific and rigid regulatory requirements— 

is both appropriate and effective. 

FINRA as Adviser SRO. Putting aside the merits of the SRO model as such, we 

strongly believe that FINRA would be an inappropriate SRO for investment advisers. As noted above, FINRA has been pursuing a role in supervising investment ad-
226 

29For example, FINRA collected more than $680 million in members fees alone in 2007. It 

charges a variety of other fees as well. See data from FINRA 2007 Annual Financial Report, 

available at http://www.finra.org/web/groups/corporate/@corp/@about/@ar/documents/corporate/p038602.pdf ; see also By-Laws of FINRA, Inc., available at: http://finra.complinet.com/ 

en/display/displaylviewall.html?rbid=2403&elementlid=4598&recordlid=5998. 30 In written testimony before this Committee, FINRA specifically referenced its belief that 

broker-dealer rules should be extended to the investment advisory profession: ‘‘The absence of 

FINRA-type oversight of the investment adviser industry leaves their customers without an important layer of protection inherent in a vigorous examination and enforcement program and 

the imposition of specific rules and requirements. It simply makes no sense to deprive investment adviser customers of the same level of oversight that broker-dealer customers receive.’’ 

Luparello Testimony, supra note 13 at p. 5. FINRA’s recent testimony echoes arguments made 

by NASD in written comments submitted to the SEC in 2005 relating to the broker-dealer exclusion under the Investment Advisers Act. See Letter of Mary L. Schapiro and Elisse B. Walter, 

NASD to Annette Nazareth and Meyer Eisenberg, SEC (Apr. 4, 2005): ‘‘[A] careful analysis of 

the relative regulatory standards shows that the substantive protections afforded broker-dealer 

customers are equivalent to, and in many cases exceed, those afforded to adviser customers.’’ 31 ‘‘Empowering the Markets Watchdog To Effect Real Results’’ by Commissioner Luis A. 

Aguilar, SEC, at North American Securities Administrators Association’s Winter Enforcement 

Conference (Jan. 10, 2009). He also noted in that speech that ‘‘the return on investment in the 

SEC is extremely high.’’ 32 Reinvigorating the Enforcement Program to Restore Investor Confidence, Speech by SEC 

Commissioner Luis A. Aguilar before the District of Columbia Bar (Mar. 18, 2009). 

visers for some time. We have serious concerns about FINRA, its governance structure, costs imposed on its members, 29 areas of expertise, and track record. 

Perhaps most important, FINRA has demonstrated an agenda favoring the extension of its broker-dealer rules and requirements to investment advisers. As a result 

of this bias, we are extremely concerned that establishing FINRA as the SRO for 

investment advisers would result in a complete overhaul of investor protections set 

forth in the Investment Advisers Act, including fiduciary duty, requirements to disclose conflicts of interest, and restrictions on principal trading. 30

Given its clear preference for broker-dealer rules, we believe it would be inappropriate and counterproductive to establish FINRA as the SRO for investment advisers. Any regulator for investment advisers should, at a minimum, acknowledge and 

reflect the practices, culture, regulation, and oversight of the advisory profession. In 

light of its explicit statements favoring the broker-dealer regulatory model, FINRA 

clearly cannot serve in this capacity. Establishing FINRA as the SRO for investment 

advisers would eviscerate the ‘‘self’’ in self-regulation. Instead, it would lead to an 

extension of the broker-dealer regulatory model to the advisory profession. 

In any case, it is far too premature to consider the possibility of an SRO for investment advisers. Instead, as discussed below, there are several other steps that 

should be taken to bolster the resources of the SEC, which is in a much better position to regulate and oversee the advisory profession consistent with its mission of 

investor protection. 

The SEC’s Resources Should Be Bolstered. The adequacy of the SEC’s resources 

to appropriately oversee and examine investment advisers is a legitimate and compelling concern that deserves serious consideration and action by policy makers. We 

believe there are steps—other than the establishment of an adviser SRO—that 

should be taken to address the SEC’s resources and to ensure a robust and appropriate oversight program of the investment advisory profession. 

First, as long supported by the IAA, there must be full funding for the SEC’s regulatory and enforcement efforts. While we applaud the Administration’s recommended budget increase for the SEC, more resources are still needed. We believe 

Congress should examine alternatives to allow the agency to achieve longer-term 

and more stable funding. SEC Commissioner Luis Aguilar, for example, has spoken 

in favor of a self-funding mechanism for the SEC, stating that self-funding ‘‘would 

greatly enhance the SEC’s ability to advance its mission.’’ 31 As he noted in a recent 

speech: 

Being self-funded is not a novel idea. In addition to the Federal Deposit Insurance Corporation, other regulators that are independently funded include the Office of Thrift Supervision, Office of the Comptroller of the Currency, and the Federal Reserve, to name a few. There is no logical reason 

to treat the SEC differently, and many reasons to similarly empower the 

Commission. 32

Congress should consider providing the SEC with the ability to budget and selffund its operations. In this challenging environment, the SEC should be able to set 
227 

33See Testimony of Lynn Turner, March 10 Banking Committee Hearing, at p.16 (‘‘The SEC 

has been chronically underfunded. A dedicated, independent financing arrangement, such as 

that enjoyed by the Federal Reserve, would be useful and is long overdue’’). 34To illustrate the effect of such a change, as of April 2008, there were more than 3,700 SECregistered advisers that reported assets under management (AUM) between $25–100 million. 35See S. Rpt. 104-209, supra note 20. 36Testimony of Andrew J. Donohue, Lori Richards, Erik Sirri, Linda Chatman Thomsen, Andrew Vollmer, U.S. Securities and Exchange Commission, before the House Committee on Financial Services, Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises, Concerning Investor Protection and Securities Fraud (Feb. 4, 2009). 37Testimony of March L. Schapiro, before the Subcommittee on Financial Services and General Government, House Committee on Appropriations, (Mar. 11, 2009). 38See IAA Letter, supra note. 27. 

long-term budgets, be able to react to changing markets and new products and services, and be able to adjust its staffing as appropriate. 33

Second, we recommend that the SEC increase the $25 million threshold that separates federally registered and state-registered advisers. An increase in the $25 million level would reduce the number of SEC-registered advisers (such advisers would 

be subject to regulation and oversight of state securities regulators). 34 The allocation of responsibility between the states and the SEC set forth in the Coordination 

Act has worked well, and the Act explicitly contemplated that the threshold would 

be regularly re-evaluated and adjusted. 35 Although the SEC has authority to do so, 

in more than 12 years since enactment of the law, the SEC has never, to our knowledge, initiated any formal review or proceeding to determine whether the threshold 

should be increased. In considering such action, the SEC obviously needs to coordinate closely with the North American Securities Administrators Association 

(NASAA) to ensure that state securities regulators are comfortable with any increased AUM level. 

Third, we believe the SEC can and should improve its inspection program for investment advisers. We recognize that the number of investment advisers has outgrown the SEC’s ability to conduct frequent examinations of the adviser population. 

In addition to the funding and threshold recommendations discussed above, there 

are steps the SEC can take to make more effective use of its resources with respect 

to examinations. For example, the SEC should consider revamping its inspection 

program to focus more on finding fraud and misappropriation of client funds as opposed to technical rules violations. In this vein, the SEC’s inspection office has recently begun a series of focused examinations related to custody-related issues. SEC 

staff testified recently that it is considering a number of potential changes and improvements to its oversight program, including the ‘‘examination frequencies for investment advisers.’’ 36

These and other measures should be fully explored to implement meaningful reforms designed to effectuate an inspection program that focuses on activities that 

harm investors and pose the greatest risks. Chairman Schapiro recently testified 

that the Commission plans to ‘‘use additional technology funding to improve our 

ability to identify emerging risks to investors.’’ She noted that the SEC needs better 

mechanisms to gather, link, and analyze data ‘‘to determine which firms or practices 

deserve a closer look.’’ 37 In our recent letter to Chairman Schapiro on self-custody 

issues, 38 we recommended enhanced disclosures by investment advisers regarding 

custody arrangements, indicating, among other things, that the SEC could use this 

more specific data in its risk assessment process. In that letter, we also recommended that the SEC consider joint examinations of dually registered firms. 

Steps such as enhanced training, better technology, and more specific, focused data 

could assist the SEC in better leveraging its inspection resources. 

We would be pleased to work with the Committee and the SEC to explore additional ways to ensure that all investment advisers are subject to appropriate and 

timely inspections. 

The IAA appreciates the opportunity to discuss our views on regulatory reform 

and specific issues that have been raised with respect to the Investment Advisers 

Act. We look forward to working with the Committee in the coming weeks and 

months in efforts to enhance and improve the effective and appropriate regulation 

of the financial services industry, to restore the vitality of the U.S. economy, and 

to renew investor confidence in our markets. 
228 

PREPARED STATEMENT OF RITA M. BOLGER 

SENIOR VICE PRESIDENT AND ASSOCIATE GENERAL COUNSEL, 

GLOBAL REGULATORY AFFAIRS, STANDARD & POOR’S

MARCH 26, 2009 

Mr. Chairman, Mr. Ranking Member, Members of the Committee, good morning. 

My name is Rita Bolger. I head the Global Regulatory Affairs department at Standard & Poor’s and I am pleased to appear before you today. These are unprecedented 

times and we at S&P appreciate the opportunity to work with Congress to address 

them. My testimony today covers four broad topics: 

• The current regulatory regime for credit rating agencies, including S&P Ratings 

Services, our nationally recognized statistical ratings organization (‘‘NRSRO’’); 

• The SEC’s exercise of its oversight authority under the current regime, including our implementation of recommendations made by the SEC following its recent examination; 

• Initiatives we have undertaken to help restore market confidence; and 

• Our views on potential changes to the current legislative and/or regulatory 

structure. 

Before turning to these topics, I want to state at the outset that we at S&P appreciate the seriousness of the current dislocation in the capital markets and the challenges it poses for the American and global economies. For many decades, S&P has 

effectively served the global capital markets with high quality, independent, and 

transparent credit ratings. Today, there are approximately nine million current and 

historical ratings available on our Web sites and we have ratings outstanding on 

approximately $30 trillion worth of debt. S&P has a long tradition of—and a strong 

cultural commitment to—integrity and professionalism. We recognize, however, that 

a number of our recent ratings in the structured finance area have not performed 

in line with our historical standards. We have reflected on these events and have 

made, and are continuing to make, a number of changes to enhance our processes. 

Restoring confidence in both ratings and the markets more broadly is critical. 

Workable solutions will involve both government action and private initiative. Toward that end, we have worked closely with lawmakers on potential measures and 

will continue to do so. We believe any legislative or regulatory action should reflect 

a systemic view and address all aspects of the capital markets that have contributed 

to the type of dislocation we have recently seen. Bringing together representatives 

from different areas of the capital markets, as the Committee has done in its two 

hearings on systemic risk, is in our view a productive way to work towards that 

goal. 

As discussed later in my testimony, we have done a lot of thinking about the regulatory framework for rating agencies. Appropriate regulation can provide comfort to 

investors that the information available to them—including ratings—has integrity, 

and we support measures towards that end. Having said that, we would be concerned about legislation or regulation that purported to mandate particular analytical approaches, as analytical independence is the hallmark of ratings quality and, 

in our view, an essential factor in market confidence. As addressed later on, we also 

believe internationally consistent regulation is critical given the increasingly global 

nature of the capital markets. 

The Current NRSRO Regulatory Regime 

Recent calls for regulation of credit rating agencies have arisen in large part out 

of the poor performance of structured finance securities issued between the middle 

of 2005 and the middle of 2007, the years in which ‘‘subprime’’ lending reached its 

peak. It is true that, generally speaking, our ratings on these structured finance instruments have performed worse than we anticipated. Consistent with our commitment to constant improvement, we have taken a long, hard look at the situation and 

implemented a number of measures in response. 

From a regulatory perspective, however, it is important to point out that the 

world in which virtually all of these structured finance ratings were issued is not 

the world we find ourselves in today. As the Committee is aware, the Credit Rating 

Agency Reform Act of 2006 (‘‘CRARA’’), passed in September of 2006, is the first 

comprehensive regulatory scheme for ratings agencies that choose to register as 

NRSROs. This regulatory regime was the product of several years of consideration 

and, in our view, reflects a judicious balance between oversight and analytical independence. The SEC’s implementing rules took effect on June 26, 2007. 
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Today, NRSROs such as S&P are subject to a robust regulatory regime. That regime starts with the CRARA, the first comprehensive law focused on rating agencies. The regime has two primary goals: 

• Promoting competition in the rating agency industry, thereby furthering ratings 

quality; and 

• Providing for regulatory oversight to promote integrity in the ratings process. 

We believe both goals have been significantly advanced in the short time since 

the CRARA became effective in the second half of 2007. On competition, the number 

of NRSROs has grown to ten, double what it was at the time the CRARA was enacted. Moreover, the SEC now requires NRSROs to disclose detailed performance 

data about their ratings, which facilitates comparisons and promotes competition. 

Going forward, we expect competition among NRSROs to continue to grow under the 

CRARA. 

The current regime also includes a vigorous set of rules. As noted, the first set 

of SEC rules under the CRARA became effective in June 2007. Those rules addressed a number of topics, including the resources deployed by an NRSRO, potential conflicts of interest, the misuse of nonpublic information, and potentially abusive and unfair practices. Under these rules, certain practices are prohibited outright, such as issuing ratings for entities that provided the NRSRO with ten percent 

or more of its net revenue in the most recent fiscal year. Other practices must be 

disclosed and managed, including receiving compensation for ratings analysis (from 

either issuers or subscribers) and the provision of nonratings services to issuers. The 

rules also include extensive record-keeping requirements and require public disclosure of financial information, including revenues received from large issuers. 

The SEC has continued its rule-making under the CRARA since 2007. Among 

other things, the SEC adopted additional rules earlier this year that: 

• Require enhanced disclosure of ratings performance data; 

• Require enhanced disclosures related to the rating methodologies employed by 

NRSROs; 

• Require disclosure when ratings deviate from the output suggested by models 

used in the rating process; 

• Prohibit an NRSRO from rating an issuer or security if the NRSRO provided 

recommendations to the issuer; and 

• Prohibit an NRSRO from rating an issue or issuer if it receives gifts of more 

than de minimus value. 

We have in place practices and procedures to comply with those rules that are 

in effect and are actively working to implement additional measures, as needed. We 

believe that, on the whole, the SEC’s rules will further enhance the integrity of the 

ratings process and overall ratings quality to the benefit of the markets. 

The SEC’s Exercise of Its Oversight Authority Under the Current NRSRO 

Regime 

Under the current framework, the SEC also has broad oversight and enforcement 

powers. Not only does the SEC have extensive examination and inspection authority, but it can also take disciplinary action against NRSROs—including censure, 

fines, or even revocation of their registration in certain circumstances—if it deems 

such action to be in the interest of investors. This provides a level of accountability 

that did not exist prior to the adoption of the CRARA. 

Since the effective date of the CRARA, the SEC has been exercising its oversight 

authority over S&P. In the second half of 2007, the SEC began an examination of 

our practices and procedures, with a focus on our ratings of structured finance securities. The exam, which lasted several months, involved dozens of meetings and 

interviews and the production of a significant volume of documents. 

The exam coincided with an exam by the SEC of two other NRSROs and resulted 

in a number of recommendations. These recommendations related to the following 

areas, among others: 

• Staffing and resource levels dedicated to ratings analysis, including surveillance 

of existing ratings; 

• Documentation of policies and procedures used to determine ratings on RMBS 

and CDOs; 

• Potential conflicts of interest arising from the ‘‘issuer pays’’ model; 

• Securities ownership by NRSRO employees; and 

• Internal auditing of ratings practices and procedures. 
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At S&P, we have been active in implementing the SEC’s recommendations: 

• With respect to staffing and resource levels, S&P has reorganized the new issue 

and surveillance groups in its U.S. Structured Finance department, and, more 

broadly, has developed tools for resource planning and for strengthening the 

quality of analytical resources; 

• It has long been S&P’s practice and policy to disclose its ratings processes and 

methodologies, including its processes and methodologies for U.S. RMBS and 

CDOs. Nonetheless, consistent with the SEC’s recommendation, S&P has initiated a review of its disclosures in those areas, including a review of its criteria 

administration process, a redesign of its Web site, among other things, to facilitate the publication of criteria, and a review and revision of its policies and procedures concerning the disclosure of ratings process and criteria changes; 

• S&P is in the process of implementing new policies that will further insulate 

its analysts from commercial aspects of our business. In addition to our longstanding prohibition of analyst involvement in negotiating fees or commercial 

arrangements, analysts will not participate in the process of recording fees on 

forms, will not have responsibility for retaining engagement letters, and will not 

participate in business discussions about market share statistics or other financial information such as deal pipelines and financial performance. Commercial 

activities will be conducted outside of the analytical function by nonanalytical 

business management staff and a centralized group who will handle fee negotiations and contract discussions. In addition, consistent with current practice, no 

personnel engaged in commercial activities will be permitted to vote in a rating 

committee. 

• S&P is also enhancing its existing personnel policies and procedures, including 

realigning performance goals for compensation and compensation pools for analytical staff to further diminish any potential commercial influences on analytical processes. 

These are just some of the many steps that S&P has taken and is continuing to 

develop in response to the SEC’s recommendations. The SEC has remained in regular communication with us regarding our progress and we have provided the SEC 

with copies of adopted policies and procedures related to its recommendations. The 

SEC has also continued to follow up on our progress on the remaining recommendations, including, for example, two telephonic updates in the last 10 days. 

S&P’s Initiatives To Enhance the Ratings Process and Promote Confidence 

The restoration of investor confidence is critical to both the financial markets and 

global economy. We believe both appropriate government action and meaningful private initiatives are essential to accomplishing that goal. Therefore, it is imperative 

that all market participants take stock of what has happened and take whatever 

steps they can to promote market confidence. 

At S&P, we have been actively applying lessons from the current crisis to adopt 

a number of constructive measures. In 2008, we announced a series of initiatives 

aimed at promoting four broad objectives: (i) ensuring the integrity of the ratings 

process; (ii) enhancing analytical quality; (iii) providing greater transparency to the 

market; and (iv) more effectively educating the marketplace about ratings. To date, 

we have made significant implementation progress. For example, we have: 

• Established an Office of the Ombudsman. The Ombudsman will address concerns related to potential conflicts of interest and analytical and governance 

processes that are raised by issuers, investors, employees and other market participants across S&P’s businesses. The Ombudsman has oversight over the handling of all issues, with authority to escalate all unresolved matters, as necessary, to the CEO of McGraw-Hill and the Audit Committee of the Board of 

Directors; 

• Implemented ‘‘look back’’ reviews to ensure the integrity of ratings, whenever 

an analyst leaves to work for an issuer; 

• Instituted a rotation system for analysts; 

• Established an enterprise wide independent Risk Assessment Oversight Committee. The committee will assess all risks that could impact the integrity and 

quality of the ratings process. This committee will also assess the feasibility of 

rating new types of securities; 

• Increased our analyst training programs; 

• Invested significantly in our compliance function; 
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• Created a separate Model Validation Group to independently analyze and validate all models, developed by S&P or provided by issuers, used in the ratings 

process; 

• Implemented procedures to collect more information about the processes used 

by issuers and originators to assess the accuracy and integrity of their data and 

their fraud detection measures so that we can better understand their data 

quality capabilities; 

• With respect to increased transparency, we have published a series of articles 

addressing certain ‘‘what if’’ scenarios; and 

• With respect to investor education, we have published a ‘‘Guide to Credit Ratings Essentials’’ that provides important information about ratings and their 

role in the markets. 

As these measures demonstrate, we believe in being proactive when it comes to 

taking steps to restore market confidence. S&P has always sought to study events 

and use the lessons learned to improve. That tradition has been a hallmark of our 

success over the years and you can expect the same commitment from us going forward. 

Potential Regulatory Measures 

We also believe legislation and/or regulation can play an important role in restoring investor confidence both in ratings and the markets as a whole. Appropriate regulation can provide a level of comfort to investors that policies are being disclosed 

and enforced and that there is consistency and integrity in the ratings process. 

As noted earlier, we believe any regulatory approach should include ‘‘end-to-end’’ 

solutions. That is, legislation and/or regulation should cover all aspects of the capital markets that, taken together, contribute in a systemic way to their functioning, 

and we believe that international consistency, leading to increased transparency is 

a formula that should be workable for all market participants. With respect to ratings, we believe an appropriate combination of legislation and rule-making should 

cover not just rating agencies, but also those entities that can play a role in promoting the quality of ratings and their appropriate use. For example, an important 

factor in ratings quality is the reliability of information available to be analyzed. 

That information is not generated by rating agencies, but by others—i.e., corporations, mortgage originators, underwriters, and others. Still other entities, such as 

professional audit firms in the corporate world and third-party due diligence firms 

in certain structured finance securities, are responsible for reviewing that information and verifying it. In our view, these entities and the roles they perform should 

be a part of any regulatory approach. 

To that end, earlier this month, we published an article entitled ‘‘Toward a Global 

Regulatory Framework for Credit Ratings’’ that lays out how a regulatory framework for ratings agencies that takes account of their place in the broader markets 

might work. In it, we highlight those features we think would promote sound, global 

rating agency oversight. They include: 

• Registration. One feature of a globally workable regulatory regime would be to 

have rating agencies register in the jurisdiction of their principal place of business and only allow registration of those that have in place standards to promote ratings integrity. From its home jurisdiction, a rating agency could be recognized to do business in other jurisdictions pursuant to a notice filing with the 

local regulator. This ‘‘passport’’ would allow for a streamlined and consistent 

regulatory approach across all the jurisdictions in which the credit rating agency conducts business. Regulators could consider limiting regulation to agencies 

whose ratings are used in local laws or regulations. 

• Performance Measurement. Another feature would be to require registered rating agencies to publicly issue performance measurement statistics over the 

short, medium, and long term, and across asset classes and geographies. 

• Disclosure of Rating Methodologies. Registered credit rating agencies could also 

be required to make robust disclosures regarding the analytical bases of their 

ratings opinions, the type of information used to arrive at ratings, and their internal standards for promoting consistency and for monitoring and updating 

ratings. With greater transparency of credit rating agency methodologies, investors would be in a better position to assess the opinions. 

• Control Over Nonpublic Information and Disclosure of Underlying Data. By 

having access to nonpublic information, rating agencies are in a position to provide more informed analysis, thus potentially enhancing the quality of the ratings they provide. Accordingly, any regulatory regime for credit rating agencies 
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should ensure that agencies have policies and procedures requiring their employees to treat nonpublic information confidentially. 

• Organizational Transparency. Registered credit rating agencies should be required to disclose detailed information about their organization’s structure, including their resources, their independence from any particular issuer, their 

ability to train and retain employees, and the independence of commercial from 

analytical functions. Rating agencies should provide pertinent information 

about their financial resources to regulators on a confidential basis. This disclosure will allow regulators to assess the viability of agencies. 

• Development of Code of Ethics. Rating agencies should develop and disclose to 

the public a detailed code of ethics, including a description of how that code will 

be enforced and how it relates to broader principles such as existing industry 

or regulatory standards. An independent officer or ombudsman should be established to communicate with the public regarding concerns that might arise 

about the code’s enforcement. 

• Elimination of Potential Conflicts of Interest. A regulatory regime must include 

robust standards for analyst and employee independence and the procedures for 

mitigating potential conflicts of interest in the ratings process. Regulation 

should require disclosure of such conflicts and prohibit analysts from performing commercial activities and providing consulting or advisory services to 

entities they rate. In this regard, regulation should require disclosure of the 

guidelines for analyst and issuer interaction. Regulation should prohibit analysts from being compensated based on the fees paid by the entities they directly rate. 

• Prohibitions on Anticompetitive Activity. A regulatory regime should prohibit 

unfair, abusive, or coercive activity. 

• Transparency of Models. A regulatory regime should require policies and procedures on the use and transparency of models, assumptions, and how agencies 

check their effectiveness, including through the use of third parties. 

• Accessibility. A regulatory regime should require a mechanism for ratings users 

to raise questions about methodologies and should require registered credit rating agencies to have in place personnel to answer these questions. 

• Effective Oversight. A regulatory regime should provide for effective oversight 

of registered agencies’ compliance with their policies and procedures through robust, periodic inspections. Such oversight must avoid interfering in the analytical process and methodologies, and refrain from second-guessing rating opinions. External interference in ratings analytics undermines investor confidence 

in the independence of the rating opinion and heightens moral hazard risk in 

influencing a rating outcome. 

• Analytical Independence. Regulators must preserve the analytical independence 

of rating agencies’ opinions, analytical processes, and methodologies. This independence is critical to restoring confidence in credit ratings and fostering innovation in financial services. 

• Accountability. A regulatory regime should hold registered rating agencies accountable for established breaches of the regulations without undermining analytical independence. Sanctions may include penalties proportionate to the nature and seriousness of any breach, suspending or removing an agency’s registration, and disallowing the continued use of that agency’s ratings for regulatory purposes. 

• International Consistency. Regulatory regimes globally must be consistent in applying standards. Regulators should coordinate in exercising oversight of rating 

agencies subject to regulation beyond their own borders. This will avoid inconsistent rules and inconsistent handling of infractions that would create uncertainty for analysts and users of ratings. Regulators should commit to sharing 

information subject to confidentiality undertakings. 

• Meaning of Ratings. Rating agencies should clearly explain the meaning of their 

credit ratings and what elements they do not address: for example, suitability 

of investments for any particular investor. 

• Differentiate New and Complex Ratings. A regulatory regime could require that 

new and complex ratings, including structured finance products, be differentiated in some manner to put investors on notice that potential volatility or the 

types of underlying assets/data for rating structured products may be distinguishable from factors affecting corporate and municipal ratings. 
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Each of these areas can play a meaningful role in restoring market confidence, 

but I want to highlight again two particularly important points here. The first is 

analytical independence. At its core, a rating is an analytical determination. It results from a group of experienced professionals analyzing a set of facts and forming 

a judgment as to what might happen in the future. For the markets to have confidence in those ratings, they must be made independently. That means, of course, 

that they must be free of undue commercial considerations—and we are fully committed to that principle—but it also means that they must truly reflect the substantive views of the analysts making them, not the dictates of a regulator or other 

external authority. 

The second is the need for international consistency. Ratings are issued and used 

globally. This reflects one of their many benefits—their ability to provide a common 

language for analyzing risk. However, it also underscores the importance of a consistent approach to the regulation of ratings around the world. A rating produced 

under one set of regulations may not mean the same thing or address the same 

risks as one produced under another if those regulations are not compatible. Inconsistent ratings regulation could actually promote uncertainty in the markets, at a 

time when it can be least afforded. 

Some have also asked whether ratings should be used in regulations and investment guidelines. S&P has never advocated for inclusion of its ratings in any regulation or guideline. However, we do believe that if legislators and regulators choose 

to incorporate ratings in their rules as benchmarks to measure creditworthiness, 

then the use of additional benchmarks may also be warranted. For example, there 

may be additional appropriate benchmarks for market participants to choose from— 

whether in regulations, investment guidelines, or private agreements—that would 

protect against ‘‘credit cliffs’’ (i.e., situations in which a deterioration in credit quality can occur quickly and without forewarning.) In short, because ratings speak to 

creditworthiness, and not other factors that may matter to investors, they have been 

designed to and should continue to be used only for the important but limited purposes for which they are intended and supplemented with other benchmarks, as appropriate. 

Lastly, some have called for the prohibition of the ‘‘issuer pays’’ business model 

that S&P and most other NRSROs use. We believe that would be a mistake. The 

‘‘issuer pays’’ model allows for a number of benefits to the market, particularly with 

respect to transparency, that are not available under other approaches. The question as we see it however is not whether one model is ‘‘good’’ while others are not, 

but whether potential conflicts of interest—which can exist in any business model— 

are appropriately managed so that the rating process employed has integrity. Critics 

sometimes ignore that any business model under which one entity is paid by another for a service poses the potential for a conflict of interest. The key question 

is whether the rating agency is capable of producing, and does produce, independent 

and robust analysis. Thus, the focus of any legislation or regulation should be on 

taking steps to protect the integrity of the ratings process from all potential conflicts 

of interest. Many of the steps outlined above and the measures we have undertaken 

are aimed at precisely that goal. 

Conclusion 

I thank you for the opportunity to participate in this hearing. Let me also assure 

you again of our commitment to analytical excellence and our desire to continue to 

work with Congress and governments, legislatures and policymakers worldwide as 

they explore the recent troubling developments and strive to develop solutions to restore stability in the global capital markets. I would be happy to answer any questions you may have. 
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PREPARED STATEMENT OF DANIEL CURRY 

PRESIDENT, 

DBRS, INC. 

MARCH 26, 2009 

Introduction 

The recent turmoil in the financial markets has shone a spotlight on the way in 

which various market participants are regulated and the effect of that regulation 

on investor protection. DBRS is pleased to have the opportunity to address these 

important issues as they relate to one segment of the financial markets, credit rating agencies. In particular, I would like to discuss four broad areas relating to credit 

rating agency regulation and investor protection: 

1. The importance of competition in the credit rating agency industry to the safety and soundness of the capital markets; 

2. The need for uniform rating agency regulation; 

3. The need for regulatory stability; and 

4. The need for regulatory recognition of the global nature of credit ratings. 

In order to put this discussion in context, I would like to begin with an overview 

of our company. 

Overview of DBRS 

DBRS is a Toronto-based credit rating agency established in 1976 and still privately owned by its founders. With a U.S. affiliate located in New York and Chicago, 

DBRS analyzes and rates a wide variety of issuers and instruments, including financial institutions, insurance companies, corporate issuers, issuers of government 

and municipal securities and various structured transactions. The firm currently 

maintains ratings on more than 43,000 securities in approximately 35 countries 

around the globe. Since its inception, DBRS has been widely recognized as a provider of timely, in-depth and impartial credit analysis. DBRS operates on an ‘‘issuerpay’’ model, which means that our ratings are available to the public free of charge. 

DBRS is committed to ensuring the objectivity and integrity of its ratings and the 

transparency of its operations. To this end, the firm has adopted a wide range of 

internal controls designed to eliminate conflicts of interest wherever possible, and 

to disclose and manage those conflicts that cannot be eliminated. DBRS also has 

adopted a Business Code of Conduct in accordance with the Code of Conduct Fundamentals for Credit Rating Agencies developed by the International Organization 

of Securities Commissions (IOSCO). In addition to displaying its credit ratings, 

DBRS’ public Web site also discloses the firm’s ratings policies and methodologies 

as well as extensive information about how its ratings have performed over time. 

As a result of a recent SEC rule, DBRS will soon be making additional information 

about its ratings history available in a user-friendly, searchable format that will 

allow investors to compare DBRS’ ratings to those of its competitors. 

In 2003, DBRS was designated by the staff of the SEC as a full-service nationally 

recognized statistical rating organization (NRSRO)—the first non-U.S. based rating 

agency to attain that designation. Four years later, DBRS became registered as an 

NRSRO under the regulatory regime adopted pursuant to the Credit Rating Agency 

Reform Act of 2006 (Rating Agency Act). In addition to its NRSRO registration, 

DBRS has achieved broad recognition by regulators globally, including recognition 

as an External Credit Assessment Institution (ECAI) in the U.S., Canada, Switzerland, and the European Union. 

With that background, I would like to turn my attention to what DBRS sees as 

an overarching principle that should inform all efforts at regulatory reform, namely, 

the development of a competitive market for credit ratings. 

The Importance of Competition in the Credit Rating Industry 

It is no secret that the credit rating industry in the United States is dominated 

by three players: Standard and Poor’s, Moody’s, and Fitch Ratings. This situation 

developed over the course of many years, and was no doubt perpetuated by a regulatory system that gave special treatment to NRSRO credit ratings, yet made the 

process of becoming an NRSRO opaque and hard to navigate. This concentrated 

structure benefitted neither issuers nor investors, as it left the large NRSROs with 

tremendous pricing power and provided limited diversity of rating opinions to the 

market. 

Although great strides were made in opening the industry to the possibility of 

competition when Congress passed the Rating Agency Act in 2006, the actual competitive landscape has been very slow to change. DBRS submits that the continued 
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1 In an ‘‘issuer-pay’’ model, an NRSRO’s credit ratings are paid for by the obligor being rated 

or by the issuer, underwriter or sponsor of the securities being rated. Issuer-paid credit ratings 

generally are made available to the public free of charge. By contrast, in a ‘‘subscriber-pay’’ 

model, the NRSRO’s credit ratings are paid for and are available only to parties who subscribe 

to the NRSRO’s services. 

dominance of the largest rating agencies contributed to the recent turmoil in the 

structured finance market, when changes in the assumptions underlying their rating models led to rapid and dramatic ratings downgrades over a very short period 

of time. Concentrating ratings opinions in so few hands had a profound, destabilizing effect on the markets. 

As the markets now struggle to regain their footing, more work needs to be done 

to open the credit rating industry to competition. Unfortunately, although the government can be a catalyst for change in this area, the opposite seems to be occurring. 

Recognizing that the securitization markets have ceased to function and that such 

markets are crucial in providing diversified sources of liquidity to corporations and 

consumers, the Federal Reserve has created the Term Asset-Backed Securities Loan 

Facility, or ‘‘TALF.’’ The Fed has announced that in order to be eligible for this program, an asset-backed security must receive a AAA-rating from a ‘‘major’’ NRSRO, 

which it defines as Standard and Poor’s, Moody’s and Fitch. No explanation has 

been given for the creation of this new sub-category of registered credit rating agency. The result of this approach is that DBRS—with over 30 years of experience as 

a rating agency and more than six, as an NRSRO—has been deemed unqualified 

to rate TALF-eligible securities, even though several issuers have asked it to do so. 

DBRS is consulting with the Fed about this issue and understands that the discriminatory policy is being reviewed. But while this review takes place, DBRS remains unable to participate in this important recovery effort. 

The harmful effects of limiting rating agency competition under the TALF are profound, because for the foreseeable future, the TALF is likely to be the entire 

securitization market in the United States. Moreover, it is probable that the 

securitization market that emerges from this crisis will be different from the market 

that existed in the past. Therefore, by excluding all but the three largest rating 

agencies from the TALF, the government may be further entrenching the historic 

oligopoly for years to come. This not only will impede competition among existing 

NRSROs, but also will discourage the formation of new ones. 

The long-term efficiency of the capital markets requires that NRSROs be allowed 

to compete on the quality of their work, not their size or their legacy. DBRS urges 

Congress to take whatever steps are necessary to make the promise of competition 

created by the Rating Agency Act a reality. 

The Need for Uniform Regulation 

Because fostering competition among rating agencies was one of the primary goals 

of the Rating Agency Act, the statute contemplates a single regulatory regime applicable to all NRSROS: big firms and small firms; those operating on an issuer-pay 

model and those operating on a subscriber-pay model; 1 and those who use quantitative methods, qualitative methods or both to determine their credit ratings. 

DBRS endorses this commitment to neutrality and believes it fosters a diversity of 

credit rating opinions that benefits the markets. 

Unfortunately, cracks have begun to appear in this foundation. One of the most 

disturbing of these is that unequal regulatory burdens have begun to be imposed 

on issuer-pay and subscriber-pay NRSROs. In order to provide users of credit ratings, investors and other market participants with the raw data they need to compare how NRSROs initially rated an obligor or security and how they adjusted those 

ratings over time, the SEC recently adopted a rule requiring issuer-pay NRSROs 

to publish ratings history information, on a delayed basis in a user-friendly format, 

on their public Web sites. The SEC did not impose a similar requirement on subscriber-pay NRSROs, because they protested that any public disclosure of their ratings, even with a substantial time delay, would be antithetical to their business 

model. The Commission now proposes to perpetuate this disparate treatment by 

adding another disclosure requirement for issuer-pay NRSROs only. 

There has been much debate in the past few years about the relative quality and 

reliability of ratings determined under the issuer-pay and subscriber-pay business 

models. Questions also have been raised as to whether the conflicts of interest faced 

by rating agencies who are paid by issuers are more pronounced than the conflicts 

faced by rating agencies who are paid by subscribers, who may also have a stake 

in how an issuer or instrument is rated. 
245 

This debate cannot be resolved so long as investors and other market participants 

are unable to verify the ratings accuracy claims made by subscriber-based ratings 

providers. Anecdotal discussions by subscriber-pay NRSROs of ‘‘where they got it 

right’’ are no substitute for an objective, independent analysis of the universe of 

their ratings. Although DBRS appreciates the need to protect the commercial value 

of subscriber-pay NRSROs’ real-time ratings, DBRS believes that absolving such 

NRSROs from all transparency obligations is not in the best interests of investors 

or the capital markets. 

DBRS also has concerns that as more and more obligations are imposed on 

NRSROs under the Rating Agency Act, the regulatory regime will become skewed 

in favor of large rating agencies. While the incremental cost of each new rule might 

seem modest when viewed in isolation, taken as a whole, the costs of complying 

with the current regulatory regime are substantial. DBRS understands that balancing the need for robust regulation against the need for affordable regulation is 

a delicate exercise. But DBRS urges this Committee to be mindful of the fact that 

at some point, more regulation harms investors by driving reputable and credible 

rating agencies from the market. 

The Need for Regulatory Stability 

The freezing of credit and the ensuing turmoil in the global financial markets has 

sent shock waves through investors, market intermediaries, policy makers and regulators. A critical examination of whether the current regulation of credit rating 

agencies contributed to this crisis is a necessary and healthy exercise. However, any 

alteration of the existing regulatory approach must be reasoned and likely to improve the safety and soundness of the capital markets. Change for the sake of 

change will only make things worse. 

The regulatory regime established under the Rating Agency Act was implemented 

in September 2007, when the first group of NRSROs became registered. This regime 

focuses not on the substance of credit ratings, but rather on the integrity and objectivity of ratings and on the transparency of the NRSROs’ operations. It does this 

by requiring NRSROs to implement extensive internal controls on their conflicts of 

interest, their use of material nonpublic information and their business practices; 

and by requiring such firms to publicly disclose the procedures and methodologies 

they use in determining credit ratings, along with performance measurement statistics regarding those ratings. NRSROs are also obligated to keep an extensive array 

of records, which enable the SEC staff to examine registered firms’ operations in 

order to ensure compliance with the Rating Agency Act and related rules. 

In response to the subprime crisis, the SEC has recently taken steps to fortify the 

regulation of NRSROs. These steps include new restrictions on conflicts of interest, 

new recordkeeping requirements and enhanced disclosure requirements regarding 

ratings procedures, methodologies and default and transition data. An additional set 

of SEC rule proposals is pending. These latest proposals include a mechanism to discourage ratings shopping with regard to ratings for structured finance products by 

facilitating the issuance of unsolicited ratings for such products. 

DBRS endorses the fundamental characteristics of the current approach to regulating NRSROs and believes that this approach is reasonably designed to protect the 

safety and soundness of the financial markets. Since this system is barely eighteen 

months old and since the enhancements to this system have yet to take effect, 

DBRS also believes that it would be unwise to significantly overhaul or abandon the 

current regulatory regime at this time. 

No superior alternative to the current approach has been identified. Moreover, the 

costs of complying with the current requirements have been very high, and smaller 

NRSROs might be driven from the market if they are required to start over under 

a new compliance regime less than 2 years after they paid to establish the first one. 

DBRS further submits that the regulation of credit rating agencies is most effective when the regulator understands the credit rating industry. For this reason, 

DBRS sees no benefit in transferring NRSRO jurisdiction from the SEC, which has 

overseen NRSROs for 34 years, to a regulator who has no experience in this area. 

Interposing a self-regulatory body between NRSROs and the SEC would be the 

worst idea of all, since it would lead to duplicative regulation by a costly private 

bureaucracy that may or may not know anything about the industry. A far better 

approach would be to make sure that the SEC has the resources it needs to effectively examine NRSROs and to take any enforcement actions that may be warranted under the existing laws and rules. 

Recognition of the Global Nature of Credit Ratings 

Given recent events, there can be no question that the financial markets are 

interdependent and global in nature. One of the core benefits of credit ratings is 
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they are globally comparable. That is, they are designed to help investors understand risk across borders. Because the ratings activities of NRSROs are not confined 

to the United States, it is important that U.S. policy makers and regulators endeavor to harmonize NRSRO regulation with the regulatory regimes of other major markets, to the extent this can be done without compromising safety and soundness. 

In this regard, DBRS notes that while the Rating Agency Act and the SEC’s rules 

thereunder are not identical to international standards such as the IOSCO Code of 

Conduct Fundamentals for Credit Rating Agencies, the U.S. law and rules address 

the same basic principles as the IOSCO Code and they do so in a way that allows 

NRSROs to comply comfortably with both. 

Ensuring that credit rating agency regulation continues to be as globally consistent as possible will encourage competition in this market among firms of varying 

size and business models. This, in turn, will help to ensure ratings stability and accuracy and will increase the availability of information to investors for their decision-making. Conversely, a balkanized system of regulation will increase costs and 

drive smaller rating agencies from the market. The result will be the continuation 

of the rating agency oligopoly with all the attendant risks to the market that the 

Rating Agency Act was designed to eliminate. 

I appreciate having the opportunity to present DBRS’ views here today and I look 

forward to answering any questions you may have. 
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RESPONSE TO WRITTEN QUESTIONS OF SENATOR MENENDEZ 

FROM MARY L. SCHAPIRO 

Q.1. Business Development Companies (BDCs), which are regulated under the Investment Company Act, support more than 

10,000 jobs in my home State of New Jersey through their extension of credit and investments in more than 20 small and middlemarket companies. I understand that the BDC industry has largely 

ceased to extend credit due to certain Investment Company Act 

rules that, in the current market environment, may be having unintended consequences. 

Does the Commission intend to address this problem, and if so, 

could the Committee expect to receive a report on the Commission’s 

actions? 

A.1. Over the past year, the greatest challenges to BDCs have resulted from market conditions rather than regulatory restrictions. 

The dearth of available credit, with the general decline in the value 

of financial assets, has severely limited the ability of BDCs to raise 

new capital to invest in small and middle-market companies. During the year ending on March 31, 2009, the net asset value (‘‘NAV’’) 

of the four largest BDCs declined an average of 32.5 percent. Declines in the market value of the shares of these BDCs were more 

severe, and shares of all four BDCs trade at significant discounts 

to NAV. The two largest BDCs are in default under their loan 

agreements, and their auditors have raised going concern issues. 

As detailed below, the staff generally believes that the regulatory 

requirements for BDCs are operating as intended. The staff also 

generally believes that improvements in the availability of credit 

and in the market values of assets held by BDCs are far more likely to enable BDCs to raise additional capital, and extend credit to 

small and middle-market companies, than regulatory relief. 

The Relevant Regulatory Requirement for BDCs Under the Investment Company Act of 1940 (‘‘Act’’) 

BDCs are a type of closed-end investment company regulated 

under the Act. The Act’s capital structure requirements limit the 

ability of a BDC to raise additional capital by issuing preferred 

stock or incurring debt. Specifically, the Act prohibits a BDC from 

issuing or selling preferred stock or incurring debt (or declaring 

cash dividends on its common stock or repurchasing its common 

stock), unless immediately thereafter the BDC has asset coverage 

of its preferred stock plus debt securities of at least 200 percent. 

These requirements are more permissive than the Act’s requirements for other closed-end investment companies whose debt securities must have asset coverage of at least 300 percent. In addition, 

a BDC may issue multiple classes of debt securities, but other 

closed-end investment companies may issue only one class of debt 

security. 

The Act’s asset coverage requirement for BDCs exists for the protection of both investors in common stock on one hand and investors in debt securities or preferred stock on the other hand. As the 

percentage of a BDC’s capital from preferred stock or debt increases, the risk to the common stockholders also increases. At the 

same time, the risk also increases that the BDC will lack the resources to pay promised interest or dividends or the principal or 
248 

liquidation preference to the holders of the debt securities or preferred shares. In this regard, Section 1(b) of the Act states that the 

national interest is adversely affected ‘‘when investment companies 

by excessive borrowing and the issuance of excessive amounts of 

senior securities [i.e., preferred stock or debt securities] increase 

unduly the speculative character of their junior securities [i.e., common stock]’’ or ‘‘fail to protect the preferences and privileges of the 

holders of their outstanding securities.’’ Section 1(b) also states 

that the Act is to be interpreted ‘‘to mitigate and, so far as is feasible, to eliminate the conditions enumerated in this section which 

adversely affect the national public interest and the interest of investors.’’ 

The Regulatory Requirement Generally Is Operating as Intended 

The Act does not prohibit a BDC from investing all of its available capital in portfolio companies. If a BDC fully invests its capital, a subsequent decline in the value of those investments that 

cause asset coverage to dip below 200 percent does not constitute 

a violation of the Act. (However, as explained above, the Act would 

prohibit the BDC from taking on additional leverage, declaring 

cash dividends on its common stock or repurchasing its common 

stock unless its asset coverage equals at least 200 percent at that 

time.) 

The Act’s asset coverage requirement does not limit the ability 

of BDCs to raise capital by issuing additional common stock. In the 

past, some of the largest BDCs periodically issued shares priced at 

a premium to NAV. This additional equity capital, in turn, increased the BDCs’ borrowing capacity. Under the Act, a BDC may 

issue additional shares priced at a discount to NAV, provided that 

the BDC’s board makes certain findings and shareholders approve 

the offering. A number of BDCs have obtained board and shareholder authorization for such offerings. In fact, Prospect Capital 

Corporation, one of the ten largest BDCs, recently raised over $60 

million in a public offering of its common stock priced below NAV. 

To the extent that BDCs have been interested in exploring relief 

from the Act’s asset coverage requirement, the staff has given this 

issue serious and careful consideration in numerous meetings with 

BDC representatives, their accounting firms and their lawyers. The 

staff continues to engage in a dialogue with BDCs and their representatives about regulatory relief. In general, the staff believes 

that the Act’s restriction on further leverage and payment of cash 

dividends on common shares or repurchase of common shares when 

asset coverage is less than 200 percent are generally working as intended. Nevertheless, the staff has provided no-action relief from 

the asset coverage requirement to the largest BDC so that it, and 

other BDCs in similar circumstances, could make cash dividend 

payments to the extent necessary to take advantage of IRS relief 

made available to certain closed-end investment companies earlier 

this year. The staff also agreed to permit BDCs to use the shelf 

registration process for sales of shares priced below NAV. Prospect 

Capital Corporation used a shelf registration for its recent sale of 

shares priced below NAV. 

We hope that this analysis constitutes the report contemplated 

by this question, but if Senator Menendez or the Committee re-
249 

1 Available at: http://www.sec.gov/spotlight/hedgefunds/hedge-mfa2.htm#wpaper2. 2Securities Act Release No. 8828 (August 3, 2007); 72 FR 45116 (August 10, 2007). The Commission has not adopted this proposal. 3Letter from John G. Gaine, President, MFA, October 19, 2007, available at: http:// 

www.managedfunds.org/downloads/MFA%20Regulation%20D%20Comment%20Letter.pdf. 

quires additional information or updates, the staff would be 

pleased to provide it. 

Q.2. Does the Commission need any additional authority to address 

these problems, or are there legislative solutions that are necessary 

to make certain that credit continues to be made available to small 

and middle-market companies? 

A.2. The staff does not believe that additional authority would enhance the ability of BDCs to attract additional capital to invest in 

small and middle-market companies. If Congress were explicitly to 

authorize the Commission to suspend or eliminate all of the Act’s 

capital structure requirements applicable to BDCs, the staff doubts 

that lenders would be more willing to extend credit to BDCs or the 

capital markets more willing to purchase shares issued by BDCs. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED 

FROM RICHARD BAKER 

Q.1. Does the concept of the sophisticated investor, which sets certain income and asset-size limitations on investors in hedge funds, 

need to be revisited? If so, how should it be revisited? 

A.1. The Managed Funds Association (MFA) strongly supports limiting investments in hedge funds to sophisticated investors. Rule 

501 of Regulation D under the Securities Act of 1933 defines the 

term ‘‘accredited investor’’ as including: 

• (5) Any natural person whose individual net worth, or joint net 

worth with that person’s spouse, at the time of his purchase 

exceeds $1,000,000; 

• (6) Any natural person who had an individual income in excess 

of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each 

of those years and has a reasonable expectation of reaching the 

same income level in the current year . . . 

The Commission adopted these standards in 1982. In May 2003, 

the SEC held a public roundtable meeting to discuss the hedge 

fund industry. In connection with that roundtable, MFA submitted 

its ‘‘White Paper on Increasing Financial Eligibility Standards for 

Investors in Hedge Funds.’’ 1 In the White Paper, MFA proposed 

that the Commission could increase the dollar thresholds for the 

accredited investor definition to address concerns that, because of 

inflation, the thresholds no longer adequately ensured the sophistication of accredited investors. In 2007, the Securities and Exchange Commission proposed modifying the accredited investor definition to account for the effects of inflation on the thresholds. 2 In 

its comment letter to the proposed rule change, MFA supported increasing these thresholds to account for the effects of inflation. 3

MFA continues to support increasing the accredited investor 

threshold to ensure that hedge fund investors are sophisticated investors who are capable of understanding the risks associated with 
250 

4Securities Act Release No. 8041 (December 19, 2001); 66 FR 66841 (December 27, 2001). 

5Securities Act Release No. 8766 (December 27, 2006); 72 FR 403-404 (January 4, 2007) (footnote omitted). 

an investment in a hedge fund and who have the financial wherewithal to withstand the potential losses from an investment. MFA 

also supports adjusting, as appropriate, the accredited investor 

threshold to account for inflation on a going forward basis, to ensure that the threshold appropriately limits investing in hedge 

funds to sophisticated investors. 

The SEC has noted on several occasions that the objective income test in Regulation D strikes an appropriate balance between 

limiting private offerings to sophisticated investors only and promoting capital formation for companies. Prior to the SEC’s adoption of Rule 242 under the Securities Act of 1933, which was replaced by the adoption of Regulation D under the Securities Act, 

issuers relying on the private offering exemption had to make a 

subjective determination of the sophistication of the investors to 

whom they offered or sold securities. The requirement to make this 

subjective determination, however, ‘‘created uncertainty about 

whether the exemption was available and thus posed problems for 

issuers, primarily small issuers, about potential rescission liability 

should the exemption turn out to be unavailable.’’ 4 To address this 

concern, the SEC incorporated the objective standard for accredited 

investors in Regulation D. In its 2007 proposed rulemaking to 

amend the accredited investor standards, the Commission again 

recognized the appropriateness of objective thresholds, 

Before 1982, our rules generally required an issuer seeking 

to rely on section 4(2) to make a subjective determination 

that each offeree had sufficient knowledge and experience 

in financial and business matters to enable that offeree to 

evaluate the merits of the prospective investment or that 

such offeree was able to bear the economic risk of the investment. In part because of a degree of uncertainty as to 

the availability of the section 4(2) exemption, the Commission adopted Regulation D under the Securities Act in 

1982 to establish nonexclusive ‘‘safe harbor’’ criteria for 

the section 4(2) private offering exemption. 5

We recognize that asset and income tests do not necessarily 

guarantee the level of sophistication of investors, but we agree with 

the SEC that such tests do achieve an appropriate balance between 

investor protection and market certainty. Bright line, easy to understand thresholds promotes certainty, which is important to market participants and also promotes efficient and effective oversight 

by regulators. Investors who meet significant income or asset 

thresholds are more likely to have greater investment experience 

and sophistication, and therefore are better able to protect their interests than are retail investors. At the very least, these thresholds 

help ensure that investors who do not personally have such experience and sophistication have the means to engage fiduciaries who 

do have such experience to assist them in making investment decisions. Further, investors who meet such tests are likely to have the 

financial wherewithal to withstand losses that may arise from their 

investment decisions. As such, we believe that limiting hedge funds 
251 

6The term qualified purchaser is defined in section 2(a)(51) of the Investment Company Act 

of 1940 to mean: 

(A)(i) any natural person (including any person who holds a joint, community property, or 

other similar shared ownership interest in an issuer that is excepted under section 80a-3 (c)(7) 

of this title with that person’s qualified purchaser spouse) who owns not less than $5,000,000 

in investments, as defined by the Commission; 

(ii) any company that owns not less than $5,000,000 in investments and that is owned directly 

or indirectly by or for 2 or more natural persons who are related as siblings or spouse (including 

former spouses), or direct lineal descendants by birth or adoption, spouses of such persons, the 

estates of such persons, or foundations, charitable organizations, or trusts established by or for 

the benefit of such persons; 

(iii) any trust that is not covered by clause (ii) and that was not formed for the specific purpose of acquiring the securities offered, as to which the trustee or other person authorized to 

make decisions with respect to the trust, and each settlor or other person who has contributed 

assets to the trust, is a person described in clause (i), (ii), or (iv); or 

(iv) any person, acting for its own account or the accounts of other qualified purchasers, who 

in the aggregate owns and invests on a discretionary basis, not less than $25,000,000 in investments. 

(B) The Commission may adopt such rules and regulations applicable to the persons and 

trusts specified in clauses (i) through (iv) of subparagraph (A) as it determines are necessary 

or appropriate in the public interest or for the protection of investors. 

(C) The term ‘‘qualified purchaser’’ does not include a company that, but for the exceptions 

provided for in paragraph (1) or (7) of section 80a-3 (c) of this title, would be an investment 

company (hereafter in this paragraph referred to as an ‘‘excepted investment company’’), unless 

all beneficial owners of its outstanding securities (other than short-term paper), determined in 

accordance with section 80a-3 (c)(1)(A) of this title, that acquired such securities on or before 

April 30, 1996 (hereafter in this paragraph referred to as ‘‘pre-amendment beneficial owners’’), 

and all pre-amendment beneficial owners of the outstanding securities (other than short-term 

paper) of any excepted investment company that, directly or indirectly, owns any outstanding 

securities of such excepted investment company, have consented to its treatment as a qualified 

purchaser. Unanimous consent of all trustees, directors, or general partners of a company or 

trust referred to in clause (ii) or (iii) of subparagraph (A) shall constitute consent for purposes 

of this subparagraph. 

to investors who meet significant income or asset thresholds is an 

effective, if not perfect, means to ensure that only sophisticated investors invest in hedge funds. 

In 1996, Congress amended the Investment Company Act of 1940 

to, among other things, introduce an additional, heightened sophisticated investor standard, the ‘‘qualified purchaser’’ 6 standard, 

which is applicable to investors in certain kinds of hedge funds (socalled ‘‘3(c)(7) hedge funds’’). In practice, investors in 3(c)(7) hedge 

funds must meet both the accredited investor and qualified purchaser thresholds. Like the accredited investor test, the qualified 

purchaser test sets out an objective standard ($5,000,000 in investments for an individual). We believe that the qualified purchaser 

standard has worked well since its inception; however, Congress 

may want to consider whether it is appropriate to adjust the standard to account for inflation. If Congress does decide to make an adjustment to the qualified purchaser standard, it is important for 

the new standard to be objective, transparent and easy to understand. 

Q.2. What level of standardization of disclosures might help investors in hedge funds? What is the balance between disclosure for the 

protection of investors and the protection of hedge funds’ intellectual property? 

A.2. MFA and its members strongly support hedge funds providing 

an appropriate level of disclosure to investors and potential investors in hedge funds, to allow those investors to make informed investment decisions. Hedge funds do disclose a significant amount 

of information to investors because of regulatory requirements and 
252 

7To assist investors in their diligence process, MFA has published a model due diligence questionnaire, which illustrates the types of information commonly requested by investors prior to 

investing. MFA’s model DDQ is available at: http://www.managedfunds.org/downloads/ 

Due%20Dilligence%20Questionnaire.pdf. 

the requirements of investors. 7 We believe that the appropriate 

balance between disclosure to investors and protection of intellectual property is best determined between sophisticated hedge fund 

investors and hedge fund managers. Investors who believe that 

they do not have sufficient information about a hedge fund should 

not make an investment in that fund. The balance between disclosure to investors and protection of intellectual property is, of 

course, set in the context of the anti-fraud provisions of the federal 

securities laws. 

We believe that because the class of investors who can invest in 

hedge funds is limited to sophisticated investors only, those investors are able to request and receive any information they believe 

to be relevant to their investment decisions. Further, we believe 

that sophisticated investors are better able than regulators to determine what information they need and how they want that information to be presented. Any investor who fails to receive the information that it believes is material to an investment decision can 

choose not to make an investment. Because sophisticated investors 

are best able to determine what information they need, and they 

have the ability to request and receive that information (or not 

make an investment if they do not), we believe that it is neither 

necessary nor advisable to require standardized disclosures by 

hedge funds. 

While hedge funds provide a significant amount of information to 

investors, we do not believe that detailed public disclosure about 

hedge funds should be required. Public disclosure of such information could be misleading, as it would likely be incomplete data that 

would be viewed by the public outside of the proper context. Public 

investors may be inclined to take action based on this data without 

fully understanding the information, which could lead to adverse 

consequences for those public investors, for investors in the relevant hedge funds, and for the stability of the financial system as 

a whole. Public disclosure of proprietary information also harms 

the ability of market participants to establish and exit from investment positions in an economically viable manner. We believe that 

investors in hedge funds can receive the information they need to 

make informed investment decisions (and regulators can receive information reported on a confidential basis to allow them to fulfill 

their investor protection, oversight, monitoring and other regulatory functions) without the adverse consequences that would result from public disclosure of the intellectual property of hedge 

funds. 

Q.3. Is it reasonable that regulators could review detailed information such as trading positions of hedge funds overall to see where 

there might be concentrations, or is this level of analysis too difficult? If so, why? 

A.3. MFA supports the notion of a central systemic risk regulator 

(SRR) and believes that such a regulator should be responsible for 

oversight over the key elements of the entire financial system, 
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8See Testimony of the Honorable Richard H. Baker, President and Chief Executive Officer, 

Managed Funds Association, before the Committee on Banking, Housing, and Urban Affairs, 

U.S. Senate, March 26, 2009; and Testimony of the Honorable Richard H. Baker, President and 

Chief Executive Officer, Managed Funds Association, before the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, Committee on Financial Services, U.S. 

House of Representatives, March 5, 2009. 9Section 4g of the Commodity Exchange Act (CEA); 17 CFR Parts 15, 16, 17, 18, 19, and 21. 

across all relevant structures, classes of institutions and products 

of all financial system participants. 8 Factors a SRR should consider in determining whether an entity is systemically important 

should include the amount of assets of an entity, the concentration 

of its activities, and an entity’s interconnectivity to other market 

participants. 

While we acknowledge that at a minimum the hedge fund industry as a whole is of systemic relevance and, therefore, should be 

considered within the systemic risk regulatory framework; we believe that most hedge funds are not systemically significant entities 

and, thus, hedge funds, as a class, should not be singled out for 

greater scrutiny. A SRR should have the authority to request and 

receive, on a confidential basis, from those entities that it determines to be of systemic relevance, including any hedge funds, information that the regulator determines necessary or advisable to enable it to adequately assess potential risks to the financial system. 

We don’t mind reporting information within reason if systemically 

relevant, provided that the SRR provides assurance of confidentiality. 

In this respect, we also believe a SRR should not equate systemically relevant entities with entities that are too big, or too interconnected, to fail. An entity that is perceived by the market to have 

a government guarantee, whether explicit or implicit, has an unfair 

competitive advantage over other market participants. We strongly 

believe that the systemic risk regulator should implement its authority in a way that avoids this possibility and also avoids the 

moral hazards that can result from a company having an ongoing 

government guarantee against its failure. 

With respect to whether a regulator could assess an entity’s 

trade concentrations through reviewing trade positions, we provide 

the following example for comparison: 

The Commodity Futures Trading Commission currently performs 

analysis of the trading positions of market participants, including 

hedge funds, as part of its market surveillance program. For example, the CFTC operates a large-trader reporting system (LTRS) 

through which it collects daily market data and position information from clearing members, futures commissions merchants, and 

foreign brokers. 9 In this way, the CFTC conducts real-time surveillance of market participants. 

We understand that the CFTC reviews the position information 

daily and will contact a market participant that exceeds an accountability level or position limit to conduct an inquiry (note: an 

accountability level is a soft limit and exceeding it is not per se illegal, whereas a position limit is a hard limit). If a market participant exceeds an accountability level, the CFTC will inquire into the 

market participant’s positions, strategy or other rationale for exceeding the accountability level. If the CFTC is not satisfied with 

its finding, it may require the market participant to decrease its 
254 

10Section 8 of the CEA. 

position. All of this is done quietly and privately to avoid alarming 

or putting other market participants on notice and creating a market impact. 

The CFTC provides the public with aggregated data of reported 

positions via its weekly Commitments of Traders reports. The Commodity Exchange Act protects market participants by prohibiting 

the CFTC from disclosing any person’s positions, transactions, or 

trade secrets (except in limited circumstances). 10

As provided in the above example, it is possible for regulators to 

review detailed information to assess position concentrations. Similar to the CFTC’s market surveillance program, we believe it would 

be more meaningful for a SRR to review trading positions across 

all market participants that it deems systemically significant, rather than single out specific types of market participants, such as 

hedge funds. While we believe it is useful for the public to receive 

aggregated position information for specific markets (i.e., commodities), we strongly believe information reported to a systemic risk 

regulator by market participants should be kept confidential for the 

reasons discussed in our written testimony. 

A SRR is also likely to need sufficient authority and flexibility 

to adapt to changing conditions and take a forward-looking view toward risk regulation. Attempting to pre-determine what information a regulator would need would not provide sufficient flexibility 

and likely would be ineffective as a tool to address potential future 

risks. As a starting point, however, a SRR may consider collecting 

aggregated trade data from counterparties, such as banks, brokerdealers and exchanges. MFA and its members are actively engaged 

in an effort to identify the types of information and data that 

would be relevant to a SRR. While we don’t have recommendations 

yet, we are committed to being constructive participants in the regulatory reform discussions and working with policy makers to develop smart regulation. 

A systemic risk regulator’s challenge will be to understand the 

interplay and use of various financial instruments across classes of 

institutions to assess the soundness of the financial system. For 

this reason, we believe it is important that a systemic risk regulator’s mandate should be focused on the protection of the financial 

system and that other regulatory entities should continue to focus 

on investor protection and market integrity. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED 

FROM JAMES CHANOS 

Q.1. You summarized the failures we have seen during this downturn in the financial markets. From your perspective, what led to 

such a disintegration of market discipline? 

A.1. While all market participants bear some degree of responsibility for where we are today in the global equity, credit and assetbacked markets, the root cause of the severe difficulties we face can 

be found in the massive debt and the large volume of unsound 

loans made and secured beyond any reasonable level by heavily 

regulated organizations. This created a massive credit bubble that 
255 

could but only burst. Market discipline was lost as businesses 

sought ever-increasing returns in a highly competitive market, and 

rating agencies made the implausible seem highly possible which 

in turn created higher returns which fed the bubble in prices for 

assets. Transparency of value and pricing was lost which also 

played a role in the disintegration of market discipline. 

Q.2. If market discipline needs to be coupled with regulatory oversight, as you state in your testimony, what is the industry doing 

to improve market discipline—as the government is working to improve the regulatory structure? 

A.2. The recommendations for hedge fund best practices of the 

President’s Working Group Asset Managers’ Committee and the Institutional Investors’ Committee represent an important step by industry participants to raise the bar on disclosure, transparency and 

valuation. These best practices in many areas such as valuation exceed the norms of other market participants engaged in similar activities. 

Q.3. Does the concept of the sophisticated investor, which sets certain income and asset-sized limitations on investors in hedge funds, 

need to be revisited? Is so, how should it be revisited? 

A.3. That is a complex question which also opens up a discussion 

of funds of funds registered under the Investment Company Act 

that invest only in hedge funds. Since they are registered, they are 

open to retail investors without any minimum financial qualifications. CPIC did not oppose the SEC proposal to revise 3(c)(1) eligibility levels for individuals. For a full discussion please see our 

comment letter to the SEC dated March 9, 2007, a copy of which 

is attached. 

Q.4. What level of standardization of disclosures might help investors in hedge funds? What is the balance between disclosure for the 

protection of investors and the protection of hedge funds’ intellectual property? 

A.4. Better transparency, particularly for investors, is a good thing. 

Having recently served on one of the President’s Working Group’s 

Committees to develop best practices for asset managers and institutional investors, there are enhanced disclosures that could be 

adopted or, if necessary, codified. For example, managers should 

disclose more data regarding how their funds derive income and 

losses from FAS 157 Level 1, 2, and 3 assets. A fund’s annual financial statement should be audited by an independent audit firm 

subject to PCAOB oversight. Additionally, provisions could be 

adopted to assure that potential investors are provided with specified disclosures relating to the fund and its management before any 

investment is accepted. This information should include any disciplinary history and pending or concluded litigation or enforcement actions, fees and expense structure, the use of commissions 

to pay broker-dealers for research (‘‘soft dollars’’), the fund’s methodology for valuation of assets and liabilities, any side-letters and 

side-arrangements, conflicts of interest and material financial arrangements with interested parties (including investment managers, custodians, portfolio brokers and placement agents), and 

policies as to investment and trade allocations. Required disclo-
256 

sures to regulators and counterparties could also include information regarding counterparty risk, lender risk and systemic risk. Finally, Congress also should require safeguards that I have advocated for many years—simple, common-sense protections relating 

to custody of fund assets and periodic audits. 

As for disclosure of a fund’s positions, particularly short positions, it is not problematic to disclose positions on a confidential 

basis to the prudential or systemic risk regulator. Such information 

could also be aggregated on a confidential basis and used by the 

regulators. Public disclosure, however, even on a delayed basis, 

would jeopardize proprietary information/intellectual property and 

drastically undercut liquidity in the market along with the financial detective role played by short sellers. Short sellers also would 

be exposed to retaliation and trading could move to less transparent markets. 

Q.5. Is the ideal regulator someone from the industry, who understands how it works? If so, who is willing to perform this public 

service at this point in our country’s economic turmoil? 

A.5. It is imperative that regulatory staff, from examiners to enforcement, have more experience and training in the day-to-day operations of the markets they are overseeing. Staff should either 

be—or be trained by—people who have sat on trading desks, who 

have run hedge funds or who have run investment firms. While the 

pool of potential trainers may not be large, there may be some seasoned, possibly retired, Wall Street professionals who could serve 

the nation by teaching the well-schooled and well-meaning staff 

what to look for now and what to look for in the future in order 

to safeguard investments and the financial system. 

Q.6. Is it reasonable that regulators could review detailed information such as trading positions of hedge funds overall to see where 

there might be concentrations, or is this level of analysis too difficult? If so, why? 

A.6. It is possible, dependent on the criteria used to select the 

funds or trading strategies to be targeted. And all market participants with similar investments, from commercial and investment 

banks to mutual funds, should be subject to the same level of scrutiny. 
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RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED 

FROM RITA M. BOLGER 

Q.1. What recourse do investors have today to take action if they 

are frustrated about what they see as a lack of diligence on your 

part in reviewing information that is used in determining your ratings? 

A.1. Investors have ample opportunity to influence the rules under 

which NRSROs like S&P operate as regulated entities under the 

Credit Rating Agency Reform Act of 2006. That Act provides the 

Securities and Exchange Commission—acting on behalf of investors—with authority to require NRSROs to adhere to their established procedures and methodologies for assigning credit ratings, 

and otherwise to comply with a comprehensive set of SEC rules, including new rules that became effective just this month. Moreover, 

as part of this comprehensive regulatory regime, the Commission 

has powerful tools at its disposal, including the ability to subject 

NRSROs to rigorous examinations and to impose fines and other 

sanctions, including revocation of our status as an approved 

NRSRO. 

It is also worth noting that numerous private law suits that relate to our ratings have been filed on behalf of investors against 

S&P. In numerous cases currently pending across the nation, investors are asserting legal claims against S&P under Section 10(b) 

of the Securities Exchange Act of 1934; Sections 11, 12 and 15 of 

the Securities Act of 1933; the ERISA laws; and common law principles sounding in negligence, negligent misrepresentation, breach 

of fiduciary duty, fraud, breach of contract and aiding and abetting 

the alleged misconduct of others. Additionally, legal claims have 

been made by the State of Connecticut for alleged breach of that 

State’s consumer protection statute. Investors have also filed complaints with Attorneys General of various states who have considered and in some cases commenced investigations relating to alleged misconduct by S&P. 

On the specific issue of the quality of information that is used 

to determine ratings, S&P has recently taken steps to address data 

quality issues with respect to U.S. RMBS by strengthening our criteria to take account of the due diligence procedures employed by 

RMBS issuers and their agents, and other criteria enhancements 

relating to the originators and sellers of securitized loans. These 

steps were taken following discussions with both investors and 

issuers. However, S&P does not, and cannot, practically audit the 

information we receive from corporations, governmental entities, 

structured finance issuers and others in our credit rating process. 

The market has not traditionally looked to S&P to assume this role 

and it would simply not be feasible for us to do so, given the extent 

of debt issued in this country and around the world. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED 

FROM DANIEL CURRY 

Q.1. What recourse do investors have today to take action if they 

are frustrated about what they see as a lack of diligence on your 

part in reviewing information that is used in determining your ratings? 
278 

A.1. The answer to this question depends the reason for the investors’ frustration and the nature of the perceived lack of diligence. 

Frustration that derives from a misapprehension about the nature of credit ratings or the role of credit rating agencies is best 

addressed by educating investors. Credit ratings are opinions that 

assess an issuer’s ability and willingness to make timely payments 

on outstanding obligations (whether principal, interest, dividend or 

distributions) with respect to the terms of an obligation. Ratings for 

structured finance vehicles reflect an opinion on the ability of the 

pooled assets to fund repayment to investors according to each security’s priority of payments. Credit ratings are not buy, sell or 

hold recommendations, and they do not address the market price 

or trading liquidity risk of a security. 

Credit rating agencies base their ratings opinions on quantitative 

and qualitative analyses of information the rating agencies receive 

from issuers, obligors or arrangers. Although rating agencies believe the information they use is accurate and reliable, the agencies 

do not audit or verify that information. In other words, credit rating agencies are not auditors. 

DBRS makes a concerted effort to educate investors about the 

nature of credit ratings and the limitations on using ratings to 

make investment decisions. In this regard, DBRS posts a plainEnglish discussion of this topic under the Rating Policies section of 

its public Web site [www.dbrs.com]. DBRS also clearly discloses the 

fact that it does not verify or audit the information it relies on in 

formulating its credit ratings. In addition, DBRS publishes its Information Review Policy, which describes the measures the firm 

has adopted to ensure that the information it uses in assigning a 

rating is of sufficient quality to support a credible rating. 

The primary recourse for an investor who is frustrated by the nature of credit ratings or the function of credit rating agencies is to 

avoid overrelying on credit ratings in making investment decisions. 

Admittedly, this is easier to do in the corporate market, where investors have access to ample information on which to base their investment decisions, than it is in the structured finance market, 

where such public information can be hard to come by. For this 

reason, DBRS has urged the Securities and Exchange Commission 

(SEC) to take steps, such as amending Regulation AB, to require 

issuers and arrangers to provide investors with more information 

about the structure or underlying assets of securitized products. 

Competition among rating agencies provides another avenue of 

recourse for an investor frustrated with a particular agency’s behavior. There are currently ten registered Nationally Recognized 

Statistical Rating Organizations (NRSROs), each of whom is required to make information about its ratings policies and performance available to the public. DBRS strongly believes that maintaining a transparent and competitive credit ratings market allows investors to assess the sufficiency of rating agencies’ respective procedures and to select the agencies they feel produce the highest quality credit ratings. 

Another avenue of recourse involves the SEC. Investors whose 

frustration derives from a belief that a rating agency is not following its stated policies regarding the review of information can 

lodge a complaint about the rating agency with the SEC. Although 
279 

the Credit Rating Agency Reform Act of 2006 does not provide a 

private right of action, it does empower the SEC to take action 

against an NRSRO that issues credit ratings in material contravention of the NRSRO’s published procedures. 

Finally, if a rating agency’s conduct involves fraud, recklessness 

or the violation of certain securities laws and rules, a frustrated investor has recourse to the courts. 

We hope that this information assists you in your examination 

of investor protection and the regulation of the securities markets. 

DBRS would be pleased to answer any additional questions you 

may have in this area.