S. HRG. 111–58 

ENHANCING INVESTOR PROTECTION AND THE 

REGULATION OF SECURITIES MARKETS 

HEARING 

BEFORE THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED ELEVENTH CONGRESS 

FIRST SESSION 

ON 

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 10, 2009 

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

( 

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51–395 PDF 2009

S. HRG. 111–58 

ENHANCING INVESTOR PROTECTION AND THE 

REGULATION OF SECURITIES MARKETS 

HEARING 

BEFORE THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED ELEVENTH CONGRESS 

FIRST SESSION 

ON 

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 10, 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 

BRIAN FILIPOWICH, Legislative Assistant 

JULIE CHON, Senior Policy Advisor 

DREW COLBERT, Legislative Assistant 

MARK OESTERLE, Republican Deputy Staff Director 

ANDREW OLMEM, Republican Counsel 

HESTER PEIRCE, Republican Counsel 

JIM JOHNSON, Republican 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 

TUESDAY, MARCH 10, 2009 

Page 

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

Opening statements, comments, or prepared statements of: 

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

Senator Crapo ................................................................................................... 5 

WITNESSES 

John C. Coffee, Jr., Adolf A. Berle Professor of Law, Columbia University 

Law School ............................................................................................................ 6 

Prepared statement .......................................................................................... 51 

Response to written questions of: 

Senator Dodd ............................................................................................. 231 

Senator Crapo ............................................................................................ 235 

Senator Vitter ............................................................................................ 236 

T. Timothy Ryan, Jr., President and Chief Executive Officer, Securities 

Industry and Financial Markets Association ..................................................... 9 

Prepared statement .......................................................................................... 79 

Response to written questions of: 

Senator Dodd ............................................................................................. 237 

Senator Crapo ............................................................................................ 269 

Paul Schott Stevens, President and Chief Executive Officer, Investment 

Company Institute ............................................................................................... 11 

Prepared statement .......................................................................................... 83 

Response to written questions of: 

Senator Dodd ............................................................................................. 271 

Senator Crapo ............................................................................................ 301 

Mercer E. Bullard, Associate Professor, University of Mississippi School of 

Law, and President, Fund Democracy, Inc. ....................................................... 13 

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

Senator Dodd ............................................................................................. 309 

Senator Crapo ............................................................................................ 312 

Robert Pickel, Executive Director and Chief Executive Officer, International 

Swaps and Derivatives Association .................................................................... 15 

Prepared statement .......................................................................................... 129 

Response to written questions of: 

Senator Dodd ............................................................................................. 312 

Senator Crapo ............................................................................................ 313 

Damon A. Silvers, Associate General Counsel, AFL–CIO .................................... 18 

Prepared statement .......................................................................................... 133 

Senator Dodd ............................................................................................. 314 

Senator Crapo ............................................................................................ 321 

Thomas Doe, Chief Executive Officer, Municipal Market Advisors .................... 20 

Prepared statement .......................................................................................... 144 

Response to written questions of: 

Senator Dodd ............................................................................................. 328 

Senator Crapo ............................................................................................ 337 

Lynn E. Turner, Former Chief Accountant, Securities and Exchange 

Commission ........................................................................................................... 22 

Prepared statement .......................................................................................... 220 

Senator Dodd ............................................................................................. 338 

Senator Crapo ............................................................................................ 341 

Senator Vitter ............................................................................................ 341 

(III)

(1) 

ENHANCING INVESTOR PROTECTION AND 

THE REGULATION OF SECURITIES MARKETS 

TUESDAY, MARCH 10, 2009 

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC. 

The Committee met at 10:38 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. The Committee will come to order. Let me 

thank our witnesses for being here this morning, and colleagues as 

well, and just to notify the room how we will proceed. Again, there 

are only a handful of us here, but we have eight witnesses, and so 

we have got a long morning in front of us to go through these 

issues. And what I would like to do is I will make some opening 

remarks, turn to Senator Shelby, and then as long as the room 

does not all of a sudden get crowded with a lot of Members here, 

I will ask Senator Reed and Senator Bennet if you would like to 

make a couple of opening comments, and we will get right to our 

witnesses, who have supplied very thorough testimony. And if they 

each read all of their testimony, we are going to be here until Friday, in a sense. But it is very, very good and very helpful to us. 

So we will proceed along those lines and hopefully have a good, engaging morning here on a very, very critical issue. 

So I welcome all of you to the hearing this morning entitled ‘‘Enhancing Investor Protection and the Regulation of Securities Markets.’’ The purpose of today’s hearing is to examine what went 

wrong in the securities markets and to discuss how we can prevent 

irresponsible practices that led to our financial system seizing up 

from ever happening again and how to protect investors, including 

small investors, from getting burned by the kinds of serious abuses 

and irresponsible behavior that we have seen in certain quarters 

of the markets in recent years. 

We are going to hear about proposals to regulate the securities 

market so that it supports economic growth and protects investors 

rather than threatens economic stability. As important, today we 

will begin to chart a course forward—a course that acknowledges 

how complex products and risky practices can do enormous damage 

to the heart of our financial system, the American people as well, 

absent a strong foundation of consumer and investor protections. 

Half of all U.S. households are invested in some way in securities, meaning the path we choose for regulating this growth and 
2 

growing segment of our financial system will determine the futures 

not only of traders on Wall Street but of families, of course, across 

the country. A year ago this coming Saturday, the collapse of Bear 

Stearns underscored the importance role that securities play in our 

financial system today. 

When I was elected to the Senate in 1980, bank deposits represented 45 percent of the financial assets of the United States and 

securities represented 55 percent. Today, the securities sector 

dominates our financial system, representing 80 percent of financial assets, with bank deposits a mere 20 percent. 

As the securities market has expanded, so, too, has its influence 

on the lives of average citizens. Much of that expansion has been 

driven by the process known as ‘‘securitization,’’ in which everyday 

household debt is pooled into sophisticated structures, from mortgages and auto loans to credit cards and student loans. 

In time, however, Wall Street not only traded that debt, it began 

to pressure others into making riskier and riskier loans to consumers. And lenders, brokers, and credit card companies were all 

too willing to comply, pushing the middle-class family in my State 

of Connecticut and elsewhere across the country who would have 

qualified for a traditional secure product into a riskier subprime 

mortgage or giving that 17-year-old college student, who never 

should have qualified in the first place, a credit card with teaser 

rates that were irresistible but terms that were suffocating. 

As one trader said of the notorious subprime lender, they were 

moving money out of the door to Wall Street so fast, with so few 

questions asked, these loans were not merely risky, they were, in 

fact, built to self-destruct. 

As we knew it, securitization did not reallocate risk. It spread 

risk throughout our financial system, passing it on to others like 

a high-stakes game of hot potato. With no incentive to make sure 

these risky loans paid off down the road, each link in the 

securitization chain—the loan originators, Wall Street firms and 

fund managers, with the help of credit rating agencies—generated 

more risk. They piled on layers of loans into mortgage-backed securities, which were piled into collateralized debt obligations, which 

were in turn piled into CDO squared and cubed, severing the relationship between the underlying consumer and their financial institutions. 

Like a top-heavy structure built on shoddy foundations, it all, of 

course, came crashing down. I firmly believe that had the Fed simply regulated the mortgage lending industry, as Congress directed 

with the law passed in 1994, much of this could have been averted. 

But despite the efforts of my predecessor on this Committee, myself, and others over many years, the Fed refused to act. 

But the failure of regulators was not limited to mortgage-backed 

securities. As many constituents in Connecticut and elsewhere 

have told me, auction rate securities, misleadingly marketed as 

cash equivalents, left countless investors and city pension funds 

across the country with nothing when the actions failed and the securities could not be redeemed. 

As this Committee uncovered at a hearing about AIG last week, 

the unregulated credit derivatives market contributed to the largest quarterly loss in history. 
3 

In recent months, we have unearthed two massive Ponzi 

schemes, bilking consumers, investors, charities, and municipal 

pension funds out of tens of billions of dollars that two separate 

regulators failed to detect in their examinations. In January, I 

asked Dr. Henry Backe of Fairfield, Connecticut, to address this 

Committee about the losses suffered by the employees at his medical practice in the Bernard Madoff fraud. His testimony prompted 

Senator Menendez and me to urge the IRS to dedicate serious resources to helping victims like Linda Alexander, a 62-year-old telephone operator from Bridgeport, Connecticut, who makes less than 

$480 a week and lost every penny of her retirement savings. In an 

instant, the $10,000 she had saved over a lifetime evaporated because regulators has no idea a massive fraud was occurring right 

under their noses. 

This crisis is the result of what may have been the greatest regulatory failure in human history. If you need any further evidence, 

consider this: At the beginning of the credit crisis in 2008, the SEC 

regulated five investment banks under the Consolidated Supervised Entity Program: Lehman Brothers, Bear Stearns, Merrill 

Lynch, Goldman Sachs, and Morgan Stanley—names synonymous 

with America’s financial strength, having survived world wars and 

the Great Depression. And though the seeds of their destruction 

have been planted nearly a decade ago, each was sold, converted 

to a bank holding company, or failed outright inside of 6 months— 

every single one of them. 

Our task today is to continue our examination of how to begin 

rebuilding a 21st century financial structure. We do so not from the 

top down, focusing solely on the soundness of the largest institutions, with the hope that it trickles down to the consumer but, 

rather, from the bottom up, ensuring a new responsibility in financial services and a tough new set of protections for regular investors who thought these protections were already in place. 

The bottom-up approach will create a new way of regulating Wall 

Street. For the securities markets, that means examining everything, from the regulated broker-dealers and their sales practices, 

to unregulated credit default swaps. It means ensuring that the 

creators of financial products have as much skin in the game when 

they package these products as the consumers do when they buy 

them, so that instead of passing on risk, everyone shares responsibility. And that means we need more transparency from public 

companies, credit rating agencies, municipalities, and banks. 

We are going to send a very clear message that these modernization efforts, the era of ‘‘don’t ask’’—in these modernization efforts, 

the era of ‘‘don’t ask, don’t tell’’ on Wall Street and elsewhere is 

over. For decades, vitality, innovation, and creativity have been a 

source of genius of our system, and I want to see that come back. 

It is time we recognized transparency and responsibility are every 

bit as paramount, that whether we are homebuyers, city managers, 

entrepreneurs, we can only make responsible decisions if we have 

the accurate and proper information. We want the American people 

to know that this Committee will do everything in its power to get 

us out of this crisis by putting the needs of people first, from constituents like Linda Alexander, who I mentioned a moment ago, to 
4 

millions more whose hard-earned dollars are tied up in our securities markets. 

Today’s hearing will provide an opportunity to hear ideas and 

build a record upon which this Committee can legislate a way forward for the American people to rebuild confidence in these securities markets, and to put our country back on a sound economic 

footing. 

With that, I thank our witnesses again for being here, and let me 

turn to my colleague, former Chairman, Senator Shelby. 

STATEMENT OF SENATOR RICHARD C. SHELBY 

Senator SHELBY. Thank you, Chairman Dodd. 

I think the greatest challenge in dealing with this financial crisis 

is understanding its multiple, complex, and interrelated causes. 

This hearing provides us an opportunity to examine some of the 

causes that relate to our securities markets and securities regulation. 

Without presupposing the specific causes of the financial crisis, 

I think it is appropriate to conclude that a broad failure of risk 

management in the financial system led us to where we are today. 

It appears that everybody assumed that someone else was monitoring the risk. Regulators assumed that financial institutions had 

properly assessed the risk of their own activities or assumed that 

other regulators were watching what those entities were doing. 

Financial institutions failed to adequately monitor risks across 

business units and failed to thoroughly understand the risks associated with new financial products. They did not adequately assess 

either their exposures to or the health of their counterparties. 

Very sophisticated investors assumed that someone else had 

done their due diligence. Less sophisticated investors assumed, unreasonably, that asset prices would only climb. The excessive reliance on credit ratings and the failure of the market to develop a 

clearinghouse for credit default swaps are just two examples of this 

widespread market failure. The disastrous consequences of this 

nearly universal passing of the buck should serve as the guidepost 

for us and the SEC as we consider reforms. 

I think there should be clear lines of responsibility for regulators. 

Only then can Congress hold regulators accountable for their performance. It is also important not to make changes to the statutory 

and regulatory framework that would further lull market participants into believing that regulators or other market participants 

are doing their work for them. 

We cannot build a regulator big enough to be everywhere at all 

times. Market participants need to do their own due diligence before and after they make an investment decision. They need to bear 

the costs of an unwise investment, just as they reap the benefit of 

a wise investment. In the end, I believe our markets will be best 

served by the combined efforts of diligent regulators and responsible market participants working under rules that are clear and 

consistent. 

Uncertainty about the rules impedes the market from working as 

it should. Ad hoc Government actions lead private capital to sit on 

the sidelines because a change in rules can radically change a market participant’s expected return. A consistent legal framework is 
5 

an essential component of a competitive capital market. Investors 

will avoid a market if they believe the rules may change in the 

middle of the game. A clear example of this dynamic is the world 

of accounting where many are calling for the suspensions of markto-market because of the adverse impact that it is presently having 

on the books of so many companies. 

Accounting rules should be designed to ensure that a firm’s disclosures reflect economic reality, however ugly that reality may be. 

Changing the accounting rules now will simply compound investors’ wariness about investing in a market where many firms have 

bad or illiquid assets on their books. 

I will be interested in hearing from today’s witnesses on this 

topic and how the SEC can improve its efforts to protect our securities markets while also facilitating continued innovation and responsible risk taking. 

Chairman Dodd, I thank you for calling this hearing. I think you 

are on to something here. 

Chairman DODD. Well, Senator, thank you very, very much. We 

have got quite a row here of witnesses to testify. Let me turn to 

Jack Reed or Michael Bennet. Any opening quick comments, Jack? 

Senator REED. Mr. Chairman, I am very interested in hearing 

the witnesses assembled. We have an impressive panel. Thank you. 

Chairman DODD. Senator Bennet. 

Senator BENNET. Mr. Chairman, thanks for holding the hearing. 

It is from this perspective truly a row of witnesses. 

[Laughter.] 

Senator BENNET. So I will wait until we are done. 

Chairman DODD. Let me invite you as well, Senator, unless others show up, we are more than willing to have you—I am sorry I 

did not see you. If you want to move on up and join us here. 

[Laughter.] 

Chairman DODD. If not, I am fearful I may call on you as a witness here. 

Senator BENNET. Well, I have a point of view. I would be happy 

to—— 

Chairman DODD. I am sure you do—I know you do. 

Senator SHELBY. We have all sat there. 

Chairman DODD. Senator Shelby just pointed out, we have been 

in that chair before. In fact, I think I was a chair further back in 

the room a long time ago along the way. 

Senator Crapo. 

STATEMENT OF SENATOR MIKE CRAPO 

Senator CRAPO. I was in that chair on this side. I know very 

much what it is like. 

Thank you very much, Mr. Chairman. I will be very brief. I really appreciate your holding this and the other hearings that you 

have scheduled. As you know, I am very interested in this issue, 

and I look forward to working with you. And let’s get on with the 

witnesses. 

Chairman DODD. You bet. And I appreciate it. Senator Crapo has 

had a longstanding interest in reg reform issues, and he has expressed to me on numerous occasions his desire to be involved in 

this discussion, as has Senator Bennet and others. So we have 
6 

some very interested Members on the Committee who want to work 

together on this issue as we move forward in the coming weeks to 

put together a bill. 

I was listening this morning to the speech by Ben Bernanke talking about his ideas—and maybe some of our witnesses—I know you 

have prepared statements, but certainly feel free in your comments 

to react to some of his thoughts this morning. That would be welcomed as well, since he made the speech this morning—where was 

it? Brookings? 

Senator SHELBY. Foreign Relations. 

Chairman DODD. Oh, Council on Foreign Relations. 

With that, let me briefly—again, I think most of our folks here 

know our witnesses. Very briefly, we have Professor John Coffee, 

who has been before us many times. He is the Adolf A. Berle Professor of Law at Columbia’s Law School; Timothy Ryan, President 

and CEO of Securities Industry and Financial Markets Association; 

Paul Schott Stevens, President and CEO of Investment Company 

Institute; Professor Mercer Bullard, Associate Professors, University of Mississippi School of Law; Robert Pickel, who is the Executive Director and CEO of International Swaps and Derivatives Association; Damon Silvers, the Associate General Counsel of the 

AFL–CIO; and Thomas Doe, CEO of Municipal Market Advisors; 

Lynn Turner, the former Chief Accountant, U.S. Securities and Exchange Commission. 

So a good row of witnesses here to testify, and we will begin in 

the order that I have introduced you. Dr. Coffee, you seem to occupy that chair every time you come here. 

STATEMENT OF JOHN C. COFFEE, JR., ADOLF A. BERLE 

PROFESSOR OF LAW, COLUMBIA UNIVERSITY LAW SCHOOL 

Mr. COFFEE. Well, good morning, and thank you, Chairman 

Dodd, Ranking Member Shelby, and fellow Senators. I have prepared an overly long, bulky, 70-page memorandum for which I 

apologize for inflicting on you. It attempts to synthesize a good deal 

of recent empirical research by business school scholars, finance 

scholars, and even law professors, about just what went wrong and 

what can be done about it. 

I cannot summarize all that, but I would add the following two 

sentences to what Senators Dodd and Shelby very accurately said 

at the outset. The current financial crisis is unlike others. This was 

not a bubble caused by investor mania, which is the typical cause 

of bubbles. It was not a demand-driven bubble; rather, it was more 

a supply driven bubble. It was the product of a particular business 

model, a model known as the ‘‘originate-and-distribute model,’’ 

under which financial institutions, including loan originators, mortgage lenders, and investment banks, all behaved similarly and 

went to the brink of insolvency and beyond, pursuing a model. 

What is the key element of this originate-and-distribute model? 

You make lax loans. You make non-creditworthy loans because— 

because you do not expect to hold those loans for long enough to 

matter. You believe that you can transfer these loans to the next 

link in the transmission chain before you will bear the economic 

risk. 
7 

When everyone believes that—and they correctly believed that 

for a few years—then all standards begin to become relaxed, and 

we believe that as long as we can get that investment grade rating 

from the credit rating agencies, we will have no problem, and weak 

loans can always be marketed. There is no time for statistics here, 

but let me add just one. 

Between 2001 and 2006, a relatively short period, some of the 

data that I cite shows you that low-document loans in these portfolios went from being something like 28 percent in mortgagebacked securities in 2001 to 51 percent in 2006—doubling in 4 or 

5 years. Investment banks and credit rating agencies are not responding to that change. That is the essential problem. 

This gives rise to what I will call and economists call a ‘‘moral 

hazard problem,’’ and this moral hazard problem was compounded 

by deregulatory policies that the SEC and other institutions followed that permitted investment banks to increase their leverage 

dramatically between 2004 and 2006, which is only just a few years 

ago. This is yesterday we are talking about. They did this pursuant 

to the Consolidated Supervised Entity Program that you have already been discussing, and it led to the downfall of our five largest, 

most important investment banks. 

All right. Essentially, the SEC deferred to self-regulation, by 

which these five largest banks constructed their own credit risk 

models, and the SEC deferred to them. The 2008 experience shows, 

if there ever was any doubt, that in an environment of intense competition and under the pressure of equity-based executive compensation systems that tend to be very short-term oriented, selfregulation alone simply does not work. The simplest way for a financial institution to increase profitability was to increase its leverage, and it did so to the point where they were leveraged to the 

eyeballs and could not survive the predictable downturn in the economic weather. 

So what should be done from a policy perspective? Well, here is 

my first and most essential point: All financial institutions that are 

too big to fail, which really means too entangled to fail, need to be 

subjected to prudential financial oversight, what I would call ‘‘financial adult supervision,’’ from a common regulator applying a basically common although risk-adjusted standard to all these institutions, whether they are insurance companies, banks, thrifts, hedge 

funds, money market funds, or even pension plans, or the financial 

subsidiaries of very large corporations, like GE Capital. In my 

judgment, this can only be done by the Federal Reserve Board. 

That is the only person in a position to serve as what is called the 

‘‘systemic risk regulator.’’ 

I think we need in this country a systemic risk regulator, and 

specifically to define what this means, let me say there are five 

areas where their authority should be established. The Federal Reserve Board should be authorized and mandated to do the following 

five things: 

One, establish ceilings on debt-to-equity ratios and otherwise restrict leverage for all major financial institutions. 

Two, supervise and restrict the design and trading of new financial products, including, in particular, over-the-counter derivatives 
8 

and including the posting of margin and collateral for such products. 

Three, mandate the use of clearinghouses. The Federal Reserve 

has already been doing this, formulating this, trying to facilitate 

this, but mandating it is more important. And they need the authority to supervise these clearing houses, and also if they judge 

it to be wise and prudent, to require their consolidation into a single clearinghouse. 

Four, the Federal Reserve needs the authority to require the 

writedown of risky assets by financial institutions, regardless of 

whether accounting rules mandate it. The accountants will always 

be the last to demand a writedown because their clients do not 

want it. The regulator is going to have to be more proactive than 

are the accounting firms. 

Last, the Federal Reserve should be authorized to prevent liquidity crises that come from the mismatch of assets and liabilities. 

The simple truth is that financial institutions hold long-term illiquid assets which they finance through short-term paper that 

they have to roll over regularly, and that mismatch regularly 

causes problems. 

Now, under this ‘‘Twin Peaks’’ model that I am describing, the 

systematic risk regulator—presumably, the Federal Reserve— 

would have broad authority. But the power should not be given to 

the Federal Reserve to override the consumer protection and transparency policies of the SEC. And this is a co-equal point with my 

first point, that we need a systemic risk regulator. Too often, bank 

regulators and banks have engaged in what I would term a ‘‘conspiracy of silence’’ to hide problems, lest investors find out, become 

alarmed, and create a run on the bank. 

The culture of banking regulators and the culture of securities 

regulators is entirely different. Bank regulators do not want to 

alarm investors. Securities regulators understand that sunlight is 

the best disinfectant. And for the long run, just as Senator Shelby 

said, we need accounting policies that reveal the ugly truth. 

We could not be worse off now in terms of lack of public confidence. This is precisely the moment to make everyone recognize 

what the truth is and not to give any regulator the authority to 

suppress the truth under the guise of systematic risk regulation. 

For that reason, I think SEC responsibilities for disclosure, 

transparency, and accounting should be specially spelled out and 

exempted from any power that the systematic risk regulator has to 

overrule other policies. 

Now, two last points. As a financial technology, asset-based 

securitization, at least in the real estate field, has decisively failed. 

I think two steps should be done by legislation to mandate the one 

policies that I think will restore credibility to this field. 

First, to restore credibility, sponsors must abandon the originateand-distribute business model and instead commit to retain at 

least a portion of the most subordinated tranche, the riskiest assets. Some of them have to be held by the promoter because that 

is the one signal of commitment that tells the marketplace that 

someone has investigated these assets because they are holding the 

weakest, most likely to fail. That would be step one. 
9 

Step two, we need to reintroduce due diligence into the process, 

into the securitization process, both for public offerings and for 

Rule 144A offerings, which are private offerings. Right now Regulation AB deregulated; it does not really require adequately that the 

sponsor verify the loans, have the loan documentation in its possession, or to have examined the creditworthiness of the individual securities. I think the SEC can be instructed by Congress that there 

needs to be a reintroduction of stronger due diligence into both the 

public and the private placement process. 

Last point. Credit rating agencies are obviously the gatekeeper 

who failed most in this current crisis. The one thing they do not 

do that other gatekeepers do do is verify the information they are 

relying on. Their have their rating methodology, but they just assume what they are told; they do not verify it. I think they should 

be instructed that there has to be verification either by them or by 

responsible, independent professionals who certify their results to 

them. 

The only way to make that system work and to give it teeth is 

to reframe a special standard of liability for the credit rating agencies. I believe the Congress can do this, and I believe that Senator 

Reed and his staff are already examining closely the need for additional legislation for credit rating agencies, and I think they are 

very much on the right track, and I would encourage them. 

What I am saying, in closing, is that a very painful period of 

deleveraging is necessary. No one is going to like it. I think some 

responsibility should be given to the Federal Reserve as the overall 

systematic risk regulator, but they should not have authority to in 

any way overrule the SEC’s policies on transparency. 

Thank you. 

Chairman DODD. Thank you very much, Professor. 

Mr. Ryan, welcome. 

STATEMENT OF T. TIMOTHY RYAN, JR., PRESIDENT AND 

CHIEF EXECUTIVE OFFICER, SECURITIES INDUSTRY AND 

FINANCIAL MARKETS ASSOCIATION 

Mr. RYAN. Good morning. Thank you for inviting me. I appreciate being here. 

Our current financial crisis, which has affected nearly every 

American family, underscores the imperative to modernize our financial regulatory system. Our regulatory structure and the plethora of regulations applicable to financial institutions are based on 

historical distinctions between banks, securities firms, insurance 

companies, and other financial institutions—distinctions that no 

longer conform to the way business is conducted. 

The negative consequences to the investing public of this patchwork of regulatory oversight are real and pervasive. Investors do 

not have comparable protections across the same or similar financial products. Rather, the disclosures, standards of care, and other 

key investor protections vary based on the legal status of the intermediary or the product or service being offered. 

In light of these concerns, SIFMA advocates simplifying and reforming the financial regulatory structure to maximize and enhance investor protection and market integrity and efficiency. 
10 

Systemic risk, as Professor Coffee noted, has been at the heart 

of the current financial crisis. As I have previously testified, we at 

SIFMA believe that a single, accountable financial markets stability regulator, a systemic regulator, will improve upon the current system. While our position on the mission of the financial 

markets stability regulator is still evolving, we currently believe 

that its mission should consist of mitigating systemic risk, maintaining financial stability, and addressing any financial crisis, all 

of which will benefit the investing public. It should have authority 

over all markets and market participants, regardless of charter, 

functional regulator, or unregulated status. It should have the authority to gather information from all financial institutions and 

markets, adopt uniform regulations related to systemic risk, and 

act as a lender of last resort. It should probably have a more direct 

role in supervising systemically important financial organizations, 

including the power to conduct examinations, take prompt corrective action, and appoint or act as the receiver or conservator of all 

or part of systemically important organizations. 

We also believe, as a second step, that we must work to rationalize the broader regulatory framework to eliminate regulatory 

gaps and imbalances that contribute to systemic risk by regulating 

similar activities and firms in a similar manner and by consolidating certain financial regulators. 

SIFMA has long advocated the modernization and harmonization 

of the disparate regulatory regimes for investment advisory, brokerage, and other financial services in order to promote investor 

protection. 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. It would make clear to all individual investors that their 

financial professionals are obligated to treat them fairly by employing the same core standards whether the firm is a financial planner, an investment adviser, a securities dealer, a bank, an insurance agency, or any other type of financial service provider. 

The U.S. is the only jurisdiction that splits the oversight of securities and futures activities between two separate regulatory bodies. We support the merger of the SEC and the CFTC. 

We believe that the development of a clearinghouse for credit derivatives is an effective way to reduce counterparty credit risk, facilitate regulatory oversight, and, thus, promote market stability. 

In particular, we strongly support our members’ initiative to establish a clearinghouse of CDS, and we are pleased to note that ICE 

US Trust opened its doors for clearing CDS transactions yesterday. 

Finally, the current financial crisis reminds us that markets are 

global in nature, and so are the risks of contagion. To promote investor protection through effective regulation and the elimination 

of disparate regulatory treatment, we believe that common regulatory standards should be applied consistently across markets. Accordingly, we urge that steps be taken to foster greater cooperation 

and coordination among regulators in all major markets. 

Thank you. 
11 

Chairman DODD. Thank you very much for that. 

Paul, welcome. It is nice to see you and have you before the Committee. 

STATEMENT OF PAUL SCHOTT STEVENS, PRESIDENT AND 

CHIEF EXECUTIVE OFFICER, INVESTMENT COMPANY 

INSTITUTE 

Mr. STEVENS. Thank you very much, Mr. Chairman. On behalf 

of the Institute and our member funds, I thank you, Chairman 

Dodd, Senator Shelby, and all the Members of the Committee for 

making it possible for me to appear today. We serve 93 million 

American investors, as you know, and we strongly commend the 

Committee for the attention you are devoting to improving our system of financial regulation. 

I believe the current financial crisis provides a very strong public 

mandate for Congress and for regulators to take bold steps to 

strengthen and modernize regulatory oversight. Like other stakeholders, and there are many, of course, we have been thinking hard 

about how to revamp the current system. Last week, we published 

a white paper detailing a variety of reforms, and in it we recommend changes to create a regulatory framework that provides 

strong consumer and investor protection while also enhancing regulatory efficiencies, limiting duplication, closing conspicuous regulatory gaps, and frankly, emphasizing the national character of our 

financial services markets. I would like briefly to summarize the 

proposals. 

First, we believe it is crucial to improve the government’s capability to monitor and mitigate risks across the financial system, so 

ICI supports creation of a Systemic Risk Regulator. This could be 

a new or an existing agency or interagency body, and in our judgment should be responsible for monitoring the financial markets 

broadly, analyzing changing conditions here and overseas, evaluating and identifying risks that are so significant that they implicate the health of the financial system, and acting in coordination 

with other responsible regulators to mitigate these risks. 

In our paper, we stress the need to carefully define the responsibilities of a Systemic Risk Regulator as well as its relationships 

with other regulators, and I would say, Mr. Chairman, that is one 

of the points that Chairman Bernanke made in his speech today, 

to leverage the expertise and to work closely with other responsible 

regulators in accomplishing that mission. 

In our judgment, addressing systemic risk effectively, however, 

need not and should not mean stifling innovation, retarding competition, or compromising market efficiency. You can achieve all of 

these purposes, it seems to us, at the same time. 

Second, we urge the creation of a new Capital Markets Regulator 

that would combine the functions of the SEC and the CFTC. This 

Capital Markets Regulator’s statutory mission should focus sharply 

on investor protection and law enforcement. It should also have a 

mandate, as the SEC does currently, to consider whether its proposed regulations promote efficiency, competition, and capital formation. 

We suggest several ways to maximize the effectiveness of the 

new Capital Markets Regulator. In particular, we would suggest a 
12 

need for a very high-level focus on management of the agency, its 

resources, and its responsibilities, and also the establishment of 

mechanisms to allow it to stay much more effectively abreast of 

market and industry developments. 

Third, as we discuss more fully in our white paper, effective oversight of the financial system and mitigation of systemic risk will 

require effective coordination and information sharing among the 

Systemic Risk Regulator and regulators responsible for other financial sectors. 

Fourth, we have identified areas in which the Capital Markets 

Regulator needs more specific legislative authority to protect investors and the markets by closing regulatory gaps and responding to 

changes in the marketplace. In my written statement, I identify 

four such areas: hedge funds, derivatives, municipal securities, particularly to improve disclosure standards, and the inconsistent regulatory regimes that exist today for investment advisors and broker 

dealers. 

Now, as for mutual funds, they have not been immune from the 

effects of the financial crisis, nor, for that matter, have any other 

investors. But our regulatory structure, and this bears emphasizing, which grew out of the New Deal as a result of the last great 

financial crisis, has proven to be remarkably resilient, even 

through the current one. 

Under the Investment Company Act of 1940 and other securities 

laws, fund investors enjoy a range of vital protections: Daily pricing 

of fund shares with mark-to-market valuation every business day; 

separate custody of all fund assets; minimal or no use of leverage 

in our funds; restrictions on affiliated transactions and other forms 

of self-dealing; required diversification; and the most extensive disclosure requirements faced by any financial products. 

Funds have embraced this regulatory regime and they have prospered under it. Indeed, I think recent experience suggests that policymakers should consider extending some of these very same disciplines that have worked so well for us since 1940 to other marketplace participants in reaction to the crisis that we are experiencing today. 

Finally, let me comment, Mr. Chairman, briefly on money market funds. Last September, immediately following the bankruptcy 

of Lehman Brothers, a single money market fund was unable to 

sustain its $1 per share net asset value. Coming hard on the heels 

of a series of other extraordinary developments that roiled global 

financial markets, these events worsened an already severe credit 

squeeze. Investors wondered what other major financial institution 

might fail next and how other money market funds might be affected. 

Concern that the short-term fixed income market was all but frozen solid, the Federal Reserve and the Treasury Department took 

a variety of initiatives, including the establishment of a temporary 

guarantee program for money market funds. These steps have 

proved highly successful. Over time, investors have regained confidence. As of February, assets in money market funds were at an 

all-time high, almost $3.9 trillion. 

The Treasury Department’s temporary guarantee program will end no later than September 18. Funds have paid more than $800 
13 

million in premiums, yet no claims have been made and we do not 

expect any claims to be made. We do not envision any future role 

for Federal insurance of money market fund assets and we look forward to an orderly transition out of the temporary guarantee program. 

The events of last fall were unprecedented, but it is only responsible that we, the fund industry, look for lessons learned. So in November 2008, ICI formed a working group of senior fund industry 

leaders to study ways to minimize the risk to money market funds 

of even the most extreme market conditions. That group will issue 

a strong and comprehensive set of recommendations designed, 

among other things, to enhance the way money funds operate. We 

expect that report by the end of the month. We hope to place the 

executive summary in the record of this hearing, and Mr. Chairman, I would be delighted to return to the Committee, if it is of 

interest to you, to present those recommendations at a future date. 

Thank you very much. 

Chairman DODD. Thank you very much for that. We will welcome that addition to the Committee record, as well. 

Professor Bullard, thank you very much for joining us. 

STATEMENT OF MERCER E. BULLARD, ASSOCIATE PROFESSOR, UNIVERSITY OF MISSISSIPPI SCHOOL OF LAW, AND 

PRESIDENT, FUND DEMOCRACY, INC. 

Mr. BULLARD. Thank you, Chairman Dodd, Ranking Member 

Shelby, and Members of the Committee for the opportunity to appear here today. I congratulate the Committee for its thorough and 

deliberate investigation into the causes of the current financial crisis. 

Recent events have provided useful lessons on the management 

of systemic risk, prudential regulation, and investor protection in 

the investment management industry. The performance of stock 

and bond mutual funds, for example, has demonstrated the remarkable resiliency of the investment company structure in times 

of stress. As equity values have plummeted, most shareholders and 

stock funds have stood their ground, notwithstanding that they 

have the right to redeem their shares at short notice at their 

NAVs. 

There is no scientific explanation for the stability of mutual 

funds during this crisis, but I believe it is related to this redemption right, as Paul was describing a moment ago. Mutual fund investors are confident that they will receive the net asset value of 

their holdings upon redemption and they appear to believe that the 

net asset value of those shares—the net asset value will be fair and 

accurate. This confidence in the valuation and redeemability of mutual fund shares reduces the likelihood of the kind of panic selling 

that creates systemic risk and may provide a useful lesson for the 

regulation of other financial intermediaries. 

The current crisis has exposed certain investor protection issues, 

however. Many investors in target date and short-term bond funds 

have experienced investment returns that are not consistent with 

returns typical of that asset class. If a fund uses the name Target 

Date 2010, for example, its equity allocation should fall within the 

generally expected range for someone on the brink of retirement. 
14 

Similarly, a 529 plan option that is touted as appropriate for a 16- 

year-old should not lose 40 percent of its value 2 years before the 

money will be needed for college. 

Investors should be free to choose more aggressive asset allocations than those normally considered most appropriate for this situation. But funds that use a name that most investors will assume 

reflects a particular strategy should be required to invest consistent with that strategy. 

In contrast with other types of mutual funds, the performance of 

money market funds has raised systemic and prudential regulation 

concerns. Money market funds constitute a major linchpin in our 

payment system and therefore a run on these funds poses significant systemic risk. The management of this risk has been inadequate, as demonstrated by the recent run on money market funds 

following the failure of the reserve primary fund. 

There are important lessons to be learned from this experience, 

but not the lessons that some commentators have found. The 

Group of 30, for example, has recommended that the money market 

franchise be eliminated. Former Fed Chairman Volcker explained 

that if money market funds are going to talk like a bank and 

squawk like a bank, they ought to be regulated like a bank. The 

problem with this argument is that money market funds don’t fail 

like banks. 

Since 1980, more than 3,000 U.S. banks have failed, costing taxpayers hundreds of billions of dollars. During the same period, two 

money market funds have failed, costing taxpayers zero dollars. I 

agree that a regulatory rearrangement is in order, but it is banks 

that should be regulated more like money market funds. Banks 

routinely fail because they invest in risky, long-term assets while 

money market funds invest in safe, short-term assets. Insuring 

bank accounts may be necessary to protect against the systemic 

risk that a run on banks poses to the payment system, but there 

is no good reason why banks should be permitted to invest insured 

deposits in anything other than the safest assets. And there is no 

good reason why money market funds that pose the same systemic 

risk to our payment system should be left uninsured. 

I note, Chairman Dodd, you may have picked up this morning on 

Chairman Bernanke’s comments that some kind of interim insurance program may be an appropriate response to the crisis, and I 

have to disagree with Paul that the program will necessarily end 

in September. I posted an article on SSRN that deals with one thesis of how to approach money market fund insurance and I hope 

the Committee and staff will take a look at that. 

The current crisis has also exposed significant weaknesses in 

hedge fund and investment advisor regulation. For example, hedge 

funds are permitted to sell investments to any person with a net 

worth of at least $1 million, a minimum that has not been adjusted 

since 1982. This means that a hedge fund is free to sell interest 

to a recently retired couple that owns a $250,000 house and has 

$750,000 in investments, notwithstanding that their retirement income is likely to be around $35,000 a year before Social Security. 

Finally, the Madoff scandal has again reminded us of the risks 

of the SEC’s expansive interpretation of the broker exclusion from 

the definition of investment advisor. It appears that Madoff did not 
15 

register as an investment advisor in reliance on the SEC’s position 

that managing discretionary accounts could somehow be viewed as 

solely incidental to related brokerage services. This over-broad exclusion left Madoff subject only to broker regulation, which failed 

to uncover this fraud. 

The SEC has since rescinded its ill-advised position on discretionary accounts, but it continues to read the ‘‘solely incidental’’ exception so broadly as to leave thousands of brokers who provide individualized investment advice subject only to a broker’s suitability 

obligation. These brokers should be subject to the same fiduciary 

duties that other investment advisors are subject to, including the 

duty to disclose revenue sharing payments and other compensation 

that create a potential conflict with their clients’ interests. 

And finally, I would just add to the comments on the question 

of systemic or prudential regulator. I agree with Professor Coffee’s 

comments that there is something simply fundamentally inconsistent with the SEC’s investor protection role and the prudential 

role that it has not served particularly well in recent times and 

that those roles should be separated. I agree that there should be 

a Federal Prudential Regulator, which is what I would call it, that 

oversees all of those similar characteristics, such as net capital 

rules, money market fund rules, banking regulations that share 

those prudential or systemic risk concerns. It is not clear to me, 

however, that the particular types of liabilities that insurance companies hold would be suitable for one common prudential regulator, 

but that is something we don’t necessarily need to consider unless 

the Federalizing of insurance regulation begins to make additional 

progress. 

And I would also add that we need to keep in mind that there 

is a significant difference between customer protection and investor 

protection. I think when Paul was talking about a Capital Markets 

Regulator, the way I would think of capital markets as being a way 

of talking about a regulator as investor protection regulator, which 

would serve fundamentally different functions, especially in that it 

embraces risk and looks to the full disclosure of that risk as its 

principal objective as opposed to what might be viewed as customer 

protection, which is really to ensure that promised services are 

what are delivered in a fully disclosed and honest way. 

These and other issues are addressed in greater detail in my 

written submission. Thank you very much. 

Chairman DODD. Thank you very, very much. 

Mr. Pickel, we thank you for joining the Committee. 

STATEMENT OF ROBERT PICKEL, EXECUTIVE DIRECTOR AND 

CHIEF EXECUTIVE OFFICER, INTERNATIONAL SWAPS AND 

DERIVATIVES ASSOCIATION 

Mr. PICKEL. Thank you, Mr. Chairman and Ranking Member 

Shelby and Members of the Committee. Thank you for inviting 

ISDA to testify here today. We are grateful for the opportunity to 

discuss the privately negotiated derivatives business, and more 

specifically, the credit default swaps market. 

I have submitted written testimony, and as you noted, Mr. Chairman, it is a lengthy submission and so I would like to summarize 

some of the key remarks that I included in that testimony. 
16 

I think first and foremost, we need to understand that the benefits of the OTC derivatives business are significant for the American economy and American companies. They manage a broad 

range of risk using these instruments that are not central to their 

businesses, allowing them to manage these financial risks typically 

so that they can focus on the business that they run. So a borrower 

borrowing on a floating basis can use an interest rate swap to manage its exposure to exchange fixed for floating obligations. 

Currency exposure—many companies have significant operations 

around the world and have significant currency exposure and use 

currency swaps, OTC currency swaps, to manage that risk. ISDA 

itself uses currency swaps to manage its overseas exposure. 

Commodity exposure—airlines have significant exposure to fuel 

costs and they typically look to utilize OTC derivatives to manage 

that exposure. 

And finally, credit exposure—using credit derivatives, credit default swaps, exposure to suppliers or to customers where credit is 

a significant concern, companies can use these products to help 

manage that risk. 

These products also create efficiencies in pricing and wider availability of credit, particularly credit default swaps. They facilitate 

lending at lower rates, and they are critical to have available, and 

have them widely available, as we come out of this recession. I 

think they will be an important part of the ability of firms to manage credit risk as they look at these important credit issues that 

we face in this financial crisis. 

As far as the role of the credit default swaps and OTC derivatives generally in the financial crisis, first of all, I think, and this 

Committee has certainly heard testimony, the fundamental source 

of the crisis is imprudent lending, particularly in the U.S. housing 

sector, but extending to other markets, as well, credit cards and 

commercial lending as an example. We must distinguish between 

the credit default swap business and the collateralized debt obligation business. There has been reference to the originate to distribute model. That certainly applies to the securitization process 

and to the CDO process. 

In the credit default swap business, a company, a bank that has 

lent money may use a credit default swap to hedge its exposure on 

that credit. In that process, it will be maintaining its lending relationship with the borrower and it will also be taking on credit risk 

and paying a fee to the company that is selling protection. So it is 

distinctly different from the originate to distribute model. 

We certainly have heard testimony, and this Committee heard 

testimony last week on the AIG situation. I think we need to spend 

some time and this organization needs to spend some time talking 

about that. AIG obviously was significantly involved in credit default swaps. It was the means by which it took risk. But we must 

understand the poor choices, the adverse policies, and the misunderstood risk that were involved there, and this Committee 

heard a lot about that in the testimony last week, particularly from 

Mr. Polakoff from the Office of Thrift Supervision. 

These were the source of their problems, these misunderstood 

risks and poor decisions. They were contrary to the best practices 

in the industry and to the experiences of swap market participants 
17 

for the past 20 years. The fundamental decision that AIG made 

was to take on exposure to the housing market. They did that, yes, 

via credit default swaps. They also did that, as the Committee 

heard last week, in other means, as well, through their securities 

lending business, in which they actually continued to lend and take 

exposure to those markets into 2006 and 2007, when the worst of 

these securities were generated through the lending process. 

They also had a very myopic view of loss. They were only looking 

at the payout potential, the possibility they would actually have to 

pay out on these transactions. There was no consideration of the 

implications of the mark-to-market losses that they could face and 

to the effects on their capital and their liquidity. They seem to have 

completely ignored the possible effects of that. 

They relied on their AAA rating and refused to provide collateral 

from the start of their trading relationships. It takes away the discipline that collateral provides in that trading relationship. Collateral is extensively used in the OTC derivatives business to help 

manage risk and also introduce discipline to the trading relationship. They agreed, on the other hand, to provide collateral on the 

downgrade of their credit rating. That led to a falling off of a cliff, 

effectively, leading to substantial liquidity problems which eventually led to the decision to intervene. 

So yes, these decisions and policies are important to understand 

and we need to take steps to make sure that this does not happen 

again, but those relate to the decisions they made and not to the 

products themselves. The products, in fact, have performed as the 

parties intended. In fact, just yesterday, the Senior Supervisors 

Group, which is a group of senior supervisors from the G-7 countries, talked about how the CDS product had performed multiple 

times over the course of last fall and into this year in helping to 

settle transactions, credit default swaps that parties had engaged 

in, and they acknowledged that this process has been extremely effective. 

And then finally, this is a very important week in the credit default swap market. I believe Mr. Ryan referred earlier to the fact 

that one of the clearinghouses that has been talked about for 

many, many months has now actually begun to clear transactions, 

and that is a very significant development. And later this week, 

ISDA itself will introduce some changes to the standard contract 

that will facilitate the settlement of these trades in the future and 

will also facilitate moving more transactions onto a clearinghouse. 

So that is a very important development. 

There is much to be done by ISDA, by the industry, in close consultation with this Committee and other committees in Congress as 

well as the regulators here in the United States and globally and 

we are committed to be engaged in that process. We look forward 

to working with you as you analyze the causes of this financial crisis, and based on that analysis, consider changes to our regulatory 

structure with a goal to obtaining greater transparency, greater 

disclosure, and greater coordination among regulators. 

Thank you again for your time, and I look forward to your questions. 

Chairman DODD. Thank you very, very much, Mr. Pickel. 
18 

Damon Silvers. Damon, it is good to have you with us. Thank 

you. 

STATEMENT OF DAMON A. SILVERS, ASSOCIATE GENERAL 

COUNSEL, AFL–CIO 

Mr. SILVERS. Good morning, Chairman Dodd and Ranking Member Shelby. Thank you for inviting me here today. Before I begin, 

I would like to note that in addition to my role as Associate General Counsel of the AFL–CIO, I am the Deputy Chair of the Congressional Oversight Panel created by the Emergency Economic 

Stabilization Act of 2008 to oversee the TARP. While I will describe 

in my testimony aspects of the Congressional Oversight Panel’s report on regulatory reform, my testimony reflects my views alone 

and the views of the AFL–CIO unless otherwise noted and is not 

on behalf of the panel, its staff, or its chair. 

The vast majority of American investors participate in the markets as a means to secure a comfortable retirement and to send 

their children to college, as you noted, Mr. Chairman, in your opening remarks. While the spectacular frauds like the Madoff Ponzi 

scheme have generated a great deal of publicity, the bigger question is what changes must be made to make our financial system 

a more reasonable place to invest the hard-earned savings of America’s working families. 

Today, I will address this larger question at three levels: Regulatory architecture, regulating the shadow markets and the challenge of jurisdiction, and certain specific steps Congress and regulators should take to address holes in the investor protection 

scheme. 

First, with respect to regulatory architecture, the Congressional 

Oversight Panel in its special report on regulatory reform observed 

that addressing issues of systemic risk cannot be a substitute for 

a robust, comprehensive system of routine financial regulation. Investor protection within this system should be the focus of a single 

agency within the broader regulatory framework. That agency 

needs to have the stature and independence to protect the principles of full disclosure by market participants and compliance with 

fiduciary duties among market intermediaries. This has been noted 

by several of the panelists prior to me. 

This mission is in natural tension with bank regulators’ mission 

of safeguarding the safety and soundness of the banks they regulate, and that natural tension would apply to a Systemic Risk Regulator that was looking more broadly at safety and soundness 

issues. Because of these dynamics, effective investor protection requires that any solution to the problem of systemic risk prevention 

should involve the agency charged with investor protection and not 

supercede it. 

I have a more detailed document on issues associated with creating a Systemic Risk Regulator that I will provide the Committee 

following the hearing. I should just note that in relation to this, it 

is my belief that more of a group approach to systemic risk regulation rather than designating the Fed as the sole regulator would 

be preferable. 

Among the reasons for this are the issues of information sharing 

and coordination that other panelists raised, but most importantly, 
19 

the fact that the Federal Reserve in its regulatory role fundamentally works through the regional Fed banks, which are fundamentally self-regulatory in nature. Several of the prior witnesses have 

mentioned some of the problems with self-regulation on critical 

issues. Furthermore, a Systemic Risk Regulator, as we have 

learned through the TARP experience, is likely to have to expend 

public dollars in extreme circumstances. It is completely inappropriate for that function to be vested in a body that is at all selfregulatory. While the Fed could be changed, its governance could 

be changed to make it fully a public agency, that would have implications, I believe, for the Fed’s independence in its monetary policy 

role. 

Now, we have already in the Securities and Exchange Commission a regulator focused on investor protection. Although the Commission has suffered in recent years from diminished jurisdiction 

and leadership failure, the Commission remains an extraordinary 

government agency whose human capital and market expertise 

needs to be built upon as part of a comprehensive strategy for effective re-regulation of the capital markets. This point flows right 

into the issue of jurisdiction and the shadow markets. 

The financial crisis we are currently experiencing is directly connected to the degeneration of the New Deal system of comprehensive financial regulation into a Swiss cheese regulatory system 

where the holes, the shadow markets, grew to dominate the regulated markets. The Congressional Oversight Panel specifically observed that we need to regulate financial products and institutions, 

in the words of President Obama, ‘‘for what they do and not what 

they are.’’ 

The Congressional Oversight Panel’s report further stated that 

shadow institutions should be regulated by the same regulators 

that currently have jurisdiction over their regulated counterparts. 

So, for example, the SEC should have jurisdiction over derivatives 

that are written using public debt or equity securities as their underlying asset. At a minimum, the panel stated, hedge funds 

should also be regulated by the SEC in their role as money managers. 

There is a larger point here, though. Financial re-regulation will 

be utterly ineffective if it turns into a series of rifle shots at the 

particular mechanisms used to evade regulatory structures in earlier boom and bust cycles. What is needed is a return to the jurisdictional philosophy that was embodied in the founding statutes of 

Federal securities regulation: Very broad, flexible jurisdiction that 

allowed the Commission to follow changing financial market practices. 

If you follow this principle, the SEC should have jurisdiction over 

anyone over a certain size who manages public securities and over 

any contract written that references publicly traded securities. Applying this principle would require at least shifting the CFTC’s jurisdiction over financial futures to the SEC, if not merging the two 

agencies under the SEC’s leadership, as I gather some of my fellow 

panelists believe is necessary. 

Moving on to substantive reforms, beyond regulating the shadow 

markets, the Congress and the Securities and Exchange Commission need to act to shape a corporate governance and investor pro-
20 

tection regime that is favorable to long-term investors and to the 

channeling of capital to productive purposes. 

First, strong boards of publicly traded companies that the public 

invests in—having strong boards requires meaningful accountability to long-term investors. The AFL–CIO urges Congress to 

work with the SEC to ensure that long-term investors can nominate and elect psychologically independent directors to company 

boards through access to the corporate proxy. 

Second, effective investor protection requires comprehensive executive pay reform involving both disclosure governance and tax 

policy around two concepts. Equity-linked pay should be held significantly beyond retirement. And two, pay packages as a whole 

should reflect a rough equality of exposure to downside risk as well 

as to upside gain. Part of this agenda must be a mechanism for 

long-term shareholders to advise companies on their executive pay 

packages in the form of an advisory vote. 

Finally, Congress needs to address the glaring hole in the fabric 

of investor protection created by the Central Bank of Denver and 

Stoneridge cases. These cases effectively granted immunity from 

civil liability to investors for parties such as investment banks and 

law firms that are actual co-conspirators in securities frauds. 

Now, to address very briefly the international context, the Bush 

administration fundamentally saw the internationalization of financial markets as a pretext for weakening U.S. investor protections. That needs to be replaced by a commitment on the part of 

the Obama administration, the Congress, and the regulators to 

building a strong global regulatory floor in coordination with the 

world’s other major economies. However, Congress should not allow 

the need for global coordination to be an impediment or a prerequisite to vigorous action to re-regulate U.S. financial markets 

and institutions. 

Obviously, this testimony simply sketches the outline of an approach and notes some key substantive steps for Congress and the 

administration to take. While I do not speak for the Oversight 

Panel, I think I am safe in saying that the Panel is honored to 

have been asked to assist Congress in this effort and is prepared 

to assist this Committee in any manner the Committee finds useful. I can certainly make that offer on behalf of the AFL–CIO. 

Thank you. 

Chairman DODD. Thank you very much. 

Mr. Doe, we thank you for joining us, the Municipal Market Advisors. 

STATEMENT OF THOMAS DOE, CHIEF EXECUTIVE OFFICER, 

MUNICIPAL MARKET ADVISORS 

Mr. DOE. Chairman Dodd, Senator Shelby, and Committee Members, is a distinct pleasure that I come before you today to share 

my perspective on the municipal bond market. My firm, Municipal 

Market Advisors, has served for the past 15 years as the leading 

independent research and data provider to the industry. In addition, from 2003 to 2005, I served as a public member of the Municipal Securities Rulemaking Board, the self-regulatory organization 

of the industry established by Congress in 1975. 
21 

There are nearly 65,000 borrowers in the municipal market that 

are predominantly States and local governments. Recent figures 

identify an estimated $2.7 trillion in outstanding municipal debt. 

This is debt that aids our communities in meeting budgets and financing society’s essential needs, whether it is building a hospital, 

constructing a school, ensuring clean drinking water, or sustaining 

the safety of America’s infrastructure. 

A distinctive characteristic of the municipal market is that many 

of those who borrow funds—rural counties and small towns—are 

only infrequently engaged in the capital markets. As a result, there 

are many issuers of debt who are inexperienced when entering a 

transaction and are unable to monitor deals that may involve 

movement of interest rates of the value of derivative products. 

According to The Bond Buyer, the industry’s trade newspaper, 

annual municipal bond issuance was $29 billion in 1975; whereas, 

in 2007, issuance peaked at $430 billion. In the past 10 years, derivatives have proliferated as a standard liability management tool 

for many local governments. However, because derivatives are not 

regulated, it is exceptionally difficult, if not impossible, to identify 

the degree of systemic as well as specific risk to small towns and 

counties who have engaged in complex swaps and derivative transactions. 

Municipal issuers themselves sought to reduce borrowing costs in 

recent years by selling bonds with a floating rate of interest, such 

as auction rate securities. Because States and local governments do 

not themselves have revenues that vary greatly with interest rates, 

these issuers employed interest rate swaps to hedge their risk. 

Issuers use the instruments to transform their floating risk for a 

fixed-rate obligation. 

A key factor in the growth of the leverage and derivative structures was the prolific use of bond insurance. Municipal issuers are 

rated along a conservative rating scale, resulting in much lower 

ratings for school districts and States than for private sector financial and insurance companies. So although most States and local 

governments represent very little default risk to the investor, the 

penal ratings scale encouraged the use of insurance for both cash 

and derivatives in order to distribute products to investors and facilitate issuer borrowing. 

So instead of requiring more accurate ratings, the municipal industry chose to use bond insurance to enhance the issuer’s lower 

credit rating to that of the higher insurance company’s rating. 

The last 18 months have exposed the risks of this choice when 

insurance company downgrades, and auction rate security failures, 

forced numerous leveraged investors to unwind massive amounts of 

debt into an illiquid secondary market. The consequence was that 

issuers of new debt were forced to pay extremely high interest 

rates and investors were confused by volatile evaluations of their 

investments. 

The 34-year era of the municipal industry’s self-regulation must 

come to an end. Today, the market would be in a much better place 

if: 

First, the regulator were independent of the financial institutions 

that create the products and facilitate issuers’ borrowing. Municipal departments represent a relatively small contribution to a 
22 

firm’s revenue, and this inhibits MSRB board members from seeking regulatory innovation. 

Second, if the regulator were integrated into the national regime 

of regulation. Since the crisis began, we have discovered a limited 

market knowledge here in D.C., in the Federal Reserve, Treasury, 

Congress, and the SEC. I might add that when the crisis began to 

emerge in August 2007, we were immediately contacted by the New 

York Federal Reserve and the Federal Reserve itself, and are quite 

impressed in the last 18 months with their vigilance and interest 

in this sector. So integration, we believe, would speed market recovery by the shared information. 

Third, the regulator’s reach and authority needs to be extended 

to all financial tools and participants of the municipal transaction. 

This meant ratings agencies, insurers, evaluators, and investment 

and legal advisors for both the cash and swaps transactions. This 

need has become more apparent as we uncover the damaged 

issuers, and States such as Alabama, Tennessee, and Pennsylvania 

are suffering relative to interest rate swaps. 

Fourth, if the regulator were charged with more aggressively 

monitoring market data with consumers’ interests in mind. When 

I think of consumers, I think of both investors and the issuers. In 

2008, there were specific instances of meaningful transactions and 

price irregularities that should have prompted regulatory investigation to protect consumers. 

The good news is that this new era of regulatory oversight can 

be funded by the MSRB’s annual revenue in 2008 of $20-plus million, collected from the bond transactions themselves, and can be 

staffed by the current MSRB policy and administrative infrastructure. 

I should be clear. The innovations of derivatives and swaps have 

a useful application and have been beneficial for those for which 

they are appropriate. However, it is also important that these instruments become transparent and regulated with the same care as 

the corresponding municipal cash market. 

It is critical to get this right. There is simply too much at stake. 

Thank you for having me here today, and I look forward to participating in the questions of the session. 

Chairman DODD. Thank you very much, Mr. Doe. 

Lynn Turner is the former Chief Accountant at the Securities 

and Exchange Commission. Mr. Turner, we thank you. 

STATEMENT OF LYNN E. TURNER, FORMER CHIEF 

ACCOUNTANT, SECURITIES AND EXCHANGE COMMISSION 

Mr. TURNER. Thank you, Chairman Dodd and Ranking Member 

Shelby. It is always good to be here in this particular case, so I 

must commend both of you for holding this hearing on an issue 

that has not only impacted millions of investors but just literally 

everyone that has been devastated from this economy. 

I would ask that my written testimony be included in the record. 

Chairman DODD. Yes, let me make that clear. There is a lot of 

additional documentation, and some of you may want to add as 

well, and so all of that will be included as part of the record. We 

thank you for that. 
23 

Mr. TURNER. It is only 17 pages, so it is a little bit quicker read 

than Professor Coffee’s. 

Senator Dodd, I think you are right. There are really three root 

causes of this problem: people made bad loans, gatekeepers sold 

out, and a lack of regulation or regulators missing in action, quite 

frankly. And it is not the first time. As an auditor in the Southwest, in Denver, I lived through this with the S&Ls, had to do 

restructurings, workouts at that point in time. And those issues 

were all existent then, and we are back to a repeat. 

So, as Mr. Doe and Mr. Silvers indicated, I think it is especially 

important that this go-round the Committee get it right. I know 

that there is some push to try to get something done by an August 

recess. I would say it is more important to hit this target. We have 

seen the markets are serviced, a trustee of two large institutional 

investors. We have seen legislation come out that has not instilled 

that confidence to date. And we need to get it right this time so 

we instill that confidence and do not see a market of 5,000, quite 

frankly. So I would ask you to take your time, whatever is necessary, sooner better than late, but I am not sure this is one that 

can be both fast and right. 

Senator Shelby, you asked someone to comment on the mark-tomarket accounting. Being the one accountant, the one green eyeshade on this, let me say I could not agree more with you. The 

mark-to-market accounting that we are debating now is the same 

issue we debated two decades ago during the S&L crisis, and as the 

1991 GAO report stated, the failure of the banks and the S&Ls 

during that travesty, to turn around, take marks down in a timely 

manner resulted in lax regulator action, people not getting on top 

of managing the assets and problems quick enough, and contributed to a significant increase in the cost to the taxpayers of that 

bailout. And so I would again urge you to push for transparency 

here, not step on those accounting standards, and let us get the 

real numbers. 

When you look at banks like Citigroup, who are trading at a 

stock price for less than what you can buy a Happy Meal these 

days at McDonald’s, we know that the market clearly is not viewing those financials as credible, and we need to get that credibility 

back into the system. 

Certainly, as my fellow panelists mentioned, there are also gaps 

in regulation. Without a doubt, the credit derivatives market—we 

all know about that. You certainly have all heard about that as recently as this last week. But it was not so much the failure of a 

regulatory system, although things need to be fixed, as it was a 

failure of regulators to act. The Office of the Comptroller of the 

Currency, the SEC, both had risk management offices. The Federal 

Reserve had examiners day in, day out at Citigroup, and this was 

not the first time Citigroup became, for all practical purposes, insolvent and in need of a bailout. When I was at the Commission 

two decades ago, the exact same thing happened. And you ask, 

How can the Fed turn around and allow that to happen? 

I remember being in a meeting with banking regulators and the 

Chairman of the Fed some time ago, and I was asked, along with 

the Chairman of the SEC at the time, What is wrong if the banks 

are allowed to fudge the numbers a little bit? Now I think we 
24 

know. If you turn around and ask me is that who you are going 

to make our systemic regulator, I would turn around and say, ‘‘I 

would hope not.’’ Rather, I think the notion that Professor Goldsmith, the former SEC Commissioner, has advocated as the council 

or commission—I think Damon talked on it as well—is a much better approach. You have got to give us this in investors, someone 

regulating that we can trust in. The notion of prudential supervision needs to be a notion that dies. What we want is actual regulators doing their job. That is what we are turning around and paying them for. 

Now, while certainly the SEC has fallen off the track here recently, I must say that over the years it has been very successful 

in its mission to protect investors and gain their confidence. I think 

investors would be ill served and very concerned if some other regulator with a mission other than investor and consumer protection, 

first and foremost, was given that leading role to protect them. 

As the Committee crafts a solution, I simply believe a focus on 

a systemic regulator in and of itself and doing regulation around 

just a systemic regulator does not get the job done. I think a more 

comprehensive single bill is the right way to go after that. And in 

doing so, I think you should focus on a few key principles that you 

need to ensure are established: independence in the system, transparency, accountability, enforcement of law, and making sure those 

responsible for doing the job have adequate resources. 

Following these key principles, as more specifically spelled out in 

the written statement, I think there needs to be a closure of the 

regulatory gaps such as with credit derivatives; SEC oversight over 

the investment banks; certainly the mortgage brokers who brought 

this problem upon us; greater accountability established through 

governance and investor rights, including private right of actions, 

as Damon has mentioned, for credit rating agencies; assisting others in the commission of fraud. Regulators simply cannot do it all 

and will never have enough resources, so we have to give institutional investors a chance to get justice and recover money when 

there has been fraud involved. 

We need to enhance transparency and disclosure, not only by the 

issuers but also by the regulators. The testimony last week where 

the Fed would not give us the names and the details behind the 

credit derivatives and who are really getting bailed out at AIG was 

most concerning and disappointing. There needs to be improvements in self-regulation, and there obviously needs to be better enforcement of the laws and regulation. 

But in the end, no agency here, neither the CFTC, SEC, the 

banking regulators, can do it without adequate resources. For example, the Office of Compliance and Inspections at the SEC, you 

are asking them to inspect 16,000 mutual funds, 11,000-plus investment advisers with 440 people. It simply cannot be done. At a 

minimum, the SEC needs $100 million to get the type of technology 

that just brings them up to what we use on the street in the market. If they do not even have those tools, there is no way they can 

supervise and stay on top of it—$100 million in technology, and 

then they need about another $85, $90 million, just to bring staffing up to the levels they were 4 to 5 years ago. And they need it 
25 

now. They do not need it on October 1 of 2010. That needs to go 

into the budget now, not a year and a half from now. 

So I would certainly urge—and I know this is not the Appropriations Committee, but I would certainly urge the Senate to find a 

way to get them the resources. Without that, you are asking them 

to go into a gunfight with an empty gun, and we all know what 

happens then. 

So, with that, I will close and be happy to answer any questions. 

Thank you. 

Chairman DODD. Well, thank you very much, Mr. Turner, and 

what I will do in terms of time—and I will not rigidly hold people 

to it, obviously, but try and do 5 or 6 minutes, and it will give us 

a chance at least to get a round. If you go over that, don’t worry 

about it so much. We will just try to move along, because, again, 

we want to get our witnesses involved. 

The temptation here is to focus on sort of one aspect of this. 

There are a lot of issues, obviously, across the spectrum from obviously credit default swaps, transparency, corporate governance 

issues, conflicts of interest, credit rating agencies—just a lot of 

matters to pick out, so I am going to try and ask a broader question and then ask each one of you to comment on a broader question. And I think I know the answer to this one, having listened 

to all of you and I looked at your testimony. But I would like to 

ask, beginning with you, Dr. Coffee—and I think you identified 

this. But if you could make one recommendation as we are looking 

at this—and obviously we have got our hands full here in the coming weeks. 

By the way, I take the point that was raised, either by Mr. Doe 

or Mr. Turner, of getting this right and, obviously, there is a sense 

of urgency, but I think the Committee would agree that we want 

to get it done, we want to work at this very hard, but we do want 

to get it right. And so striking that balance between moving with 

some haste but not to such a degree that that becomes the goal 

rather than producing a product here that has been well thought 

out. 

But if you could make one recommendation that you feel is the 

most important legislative or regulatory action that the Committee 

could take to improve investment protection or the quality of securities regulation in the light of the financial crisis we are experiencing, what would it be? What is your one recommendation for us? 

Just go down the line. 

Mr. COFFEE. I would tell you that you should endorse—— 

Chairman DODD. I need that microphone on. 

Mr. COFFEE. I would tell you that is the twin peaks model for 

securities regulation, that is, having separate peaks—one, the systematic risk regulator, the prudential supervisor. I do not think the 

SEC is the best agency for that. By training or culture, it is a lawyer-dominated agency focused on enforcement and disclosure, 

which it does well. It is not able to deal with financial institutions, 

at least in terms of its first-line responsibilities. Someone else can 

do that better, presumably the Federal Reserve. 

But as was said by other people today, I think there is always 

the danger that the cultures of securities and banking regulation 

are so different, and if you put them all in one agency, the central-
26 

ized regulator, much like the British model, the FSA, you are going 

to have tensions and tradeoffs between investor protection and the 

protection of bank solvency. 

Thus, I think you have to have a separate investor protection 

agency. You could merge the SEC and the CFTC, or you could 

transfer financial futures to the SEC. That is going to be costly in 

terms of the political process. I do not know whether it is feasible. 

But the first step, I would say, is to try to have a systematic risk 

regulator and to not give it the authority to override the disclosure 

regulators on questions of accounting or on investor protection. So 

that is the structural issue from 40,000 feet, and I would start 

there. 

Chairman DODD. Gene Ludwig I have talked to, and he has 

talked about a similar twin peaks structure that you have just described. Are you familiar with his thoughts on this? 

Mr. COFFEE. Well, this term ‘‘twin peaks’’ has been used by a 

number of people. Around the world we see two models: the centralized regulator, which is what the U.K. has, and it has not 

worked that well there, either; and we have the twin peaks models 

which Australia, the Netherlands, and other countries have. 

We in the U.S. have a unique fragmented system that is virtually Balkanized, with a different regulator for every class of institution. We have got to move one of those two, and I am telling you 

that the twin peaks model, I think, is vastly superior. 

Chairman DODD. OK. I agree with you. 

Tim Ryan. 

Mr. RYAN. This is unique. We basically agree with the professor. 

I mean, we have not worked out most of the details on both aspects 

of the twin peak, but we know that the No. 1 recommendation we 

have today—and actually, the country needs it. We need confidence 

in the system. There is no confidence today. We need a systemic 

risk regulator for the major institutions, and we would urge you to 

do that in a timely fashion. And we would define ‘‘timely’’ by the 

end of this year, and to do it right. 

Thank you. 

Chairman DODD. Mr. Stevens. 

Mr. STEVENS. We, as you know, endorse with some cautions the 

idea of a systemic risk regulator, but if you push me to say what 

one thing, Mr. Chairman, I would say that we need a capital markets regulator that is really at the top of its game. This problem 

would not have grown unless the securities markets made available, through packaging and reselling and all the rest of it, a vast 

opportunity to take these mortgages and distribute them to financial institutions globally. 

I in 30 years have been a close observer of the SEC, and I think 

it is a remarkable agency. But it has seen challenges in keeping 

up with the growth and the complexity and the linkages, the internationalization of our capital markets. What we need to do is give 

it the right tools, give it the right range of authority, and make 

sure there is a very strong management focus there that keeps it 

on its mission. And I agree with you, investor protection is mission 

one, but it also has a very important regulatory role, and so it 

needs to understand and be able to keep pace with these market 
27 

changes in the way that has, I think, proven to be very, very difficult. 

So that would be my recommendation. 

Chairman DODD. OK. Professor Bullard. 

Mr. BULLARD. Mine would be to—probably to expand on what 

Professor Coffee was saying, I think that from an investor protection point of view, what is important to understand is that investor 

protection actually assumes that we want investors to take risk. 

And, therefore, investor protection is about making sure that the 

risks that they take are consistent with their expectations. 

That is fundamentally inconsistent with a prudential oversight 

role. Prudential oversight is what you want when somebody buys 

life insurance and expects the money to be there if their spouse 

dies. They invest in a banking account, and they expect those assets to be there. They buy a money market fund, and they expect 

that to be a safe investment. 

That is antithetical to investor protection risk because there 

sometimes the disclosure of the truth undermines the confidence 

that you need that those people rely on to keep their investments 

in banks—to keep their assets in banks and money market funds. 

So I would say those have to be separated, and investor protection 

needs to be, again, as I mentioned earlier, kept distinct from customer protection, which again is not something that needs to be 

regulated with an eye to promoting risk taking—that is, risk taking 

based on high expected value investments. 

And then, finally, I would say that I am a little concerned about 

mixing the systemic issue and the prudential issue. The way I have 

always thought about prudential oversight is that you are making 

sure that the promises made with respect to generally liabilities on 

one side are matched by the kind of assets that are created to support those liabilities. 

Systemic oversight is where you assume that prudential regulation, being necessarily imperfect, will sometimes lead to a breakdown, and the question is: What is the role of the Government 

going to be to prevent that breakdown under a prudential system, 

which will happen sometimes, and what will it do when it steps in? 

I think that that is a fundamentally separate function from prudential regulation, and that is why—and I am not sure what a systemic regulator is as apart from a prudential regulator. But that 

is something, I think, that it would help to have more clarity on. 

Chairman DODD. Yes, Mr. Pickel. 

Mr. PICKEL. I think the requirement for greater coordination 

among the regulators is very important. I think that one of the 

things we are looking at here in the financial crisis is the ability 

to connect the dots across different products and across different 

markets, both nationally and globally. I think that is the root of 

some of the suggestions for the systemic risk regulator. But I think 

it could also be achieved, as I think Mr. Silvers and Mr. Turner 

suggested, through greater coordination or some collection of supervisor who would look at these issues and connect those dots. 

Chairman DODD. Mr. Silvers. 

Mr. SILVERS. I find myself in the unusual position of having really nothing to disagree with in what I have heard so far at the table. 
28 

I would say, though, that the single item that I would put to you, 

I would put differently than my co-panelists have done so far. 

I think that conceptually the thing you want to be most focused 

on is ensuring that we no longer have a Swiss cheese system, that 

we no longer have a system where you can do something like insure a bond, either in a completely regulated fashion, in which 

there are capital requirements and disclosure requirements and 

pre-clearance, or in a completely unregulated fashion through essentially a derivative and where you have none of these things; 

that the content of what a financial market actor does should determine the extent and type of that regulation. 

Closing regulatory loopholes, ending the notion that we have 

shadow markets, I think is the most important conceptual item for 

Congress to take up, because, otherwise, if it continues to be possible to essentially undertake the same types of activity with the 

same types of risk but to do so in an unregulated fashion, we will 

replay these events with a fair degree of certainty. And I believe 

that much of what the discussion about structure here has been is 

all about how we do that ending of shadow markets and regulatory 

gaps. 

I think in certain respects, some of the how is less important 

than actually getting it done. I would say, though, that I really 

strongly endorse what Mercer said about the different functions of 

regulation, that there is investor protection, disclosure and fiduciary duty oriented; there is consumer protection, although I think, 

Mercer, you had a different phrase for it, but protection around the 

public buying financial services which does not want to take risk; 

and then there is safety and soundness regulation. Those things 

are different, and it is dangerous to blend them. 

Chairman DODD. Yes. Mr. Doe. 

Mr. DOE. As I have listened to my fellow panelists, I am reminded of a book called ‘‘Why Most Things Fail’’ by a U.K. economist named Paul Oremerod, where he draws comparisons between 

species extinction models and those of corporate and market failures. And in it, he cites two conditions where we have failure of 

a species. And one is when it gets soft and is not challenged. The 

second is when there is not incremental learning that is constantly 

being done. 

And I think what I have gathered in the last 18 months—and, 

again, in our small niche in the municipal bond industry, which is 

smaller than others that have been addressed here today. But it is 

that the idea of a regulator that has an inspired inquisitiveness 

and a sense of purpose so that they are eager to pursue an understanding of the markets that they regulate. If there has been one— 

and this is where I hope that if we have a consolidated or a sharing 

of information across the different asset classes or the different 

products, whether they be cash, whether they be swaps, whether 

they are equity, whether they are fixed income, that this provides 

an opportunity of being able to identify the first hints of failure 

that might occur in a system, and that way we might be faster to 

act. 

I think what is very interesting about, again, the industry that 

I have been involved with in the municipal bond sector is that 

when innovation of products finally makes its way into the public 
29 

sector, it is almost the last place, again, because the revenue relatively is small compared to the other asset classes in the taxable 

markets. But I think it becomes magnified because you are starting 

to deal now with the public trust in the most intimate form. 

And I think so that when we start looking at regulation, it is, 

again, how do you inspire that trust, but how do you inspire that 

inquisitiveness of the regulator, and maybe it is the pride that is 

associated with doing the job that they feel that they are really 

able to accomplish something and make a difference. And I think 

that is what we are all trying to do here. 

Thank you. 

Chairman DODD. Yes. Last, Mr. Turner. 

Mr. TURNER. I actually think if I could just pick up a magic wand 

and do one single thing here, it would make sure that inside the 

agencies, the regulators, we had competent people who were in the 

right mind-set to go do their jobs. Bad loans, the Fed had the law 

that you all passed in 1994 giving them clear-cut authority to go 

eliminate those. They did not do it. Enforcement agencies have not 

done enforcement. 

The bottom line here is much of this could have been prevented 

without a single additional piece of legislation being done if people 

had just done their jobs back here. And I would urge you, go back, 

let us make sure we get the right people in, and then let us make 

sure, quite frankly, there is more active, proactive oversight by the 

appropriate committees of those responsible. 

Aside from that, I would turn around and say the No. 1 thing 

in the system has to be independence. These agencies have to 

clearly understand they are independent and free to go do what 

they need to do to protect investors and consumers. There should 

have been independence in the credit rating agencies. They clearly 

sold out. The e-mails and all show it. That was not there. 

There needs to be independence in the compliance officers in 

these businesses, in these banks. Clearly, that was not there. 

So aside from making sure you got people doing the job, we can 

have one peak, we can have two peaks. We can have 52—the 

14,000 peaks that we have got in Colorado. But if you have got bad 

people sitting on the top of each of those peaks, it is not going to 

matter what you legislate here. 

Chairman DODD. With that encouraging note, let me turn to Senator Shelby. 

[Laughter.] 

Senator SHELBY. Mr. Turner, we are glad you are here. Thank 

you. Thank you very much. 

Professor Coffee, I would like to direct this to you, if I could. 

Thank you, and welcome to the Committee again. You spend a lot 

of time here, and we welcome you, and you have added a lot to us. 

You recommend giving the Federal Reserve Board authority to 

regulate capital adequacy, safety and soundness, and risk management of all financial institutions that are ‘‘too big to fail.’’ Is this 

suggestion based on a careful examination of the Federal Reserve’s 

track record as a prudential supervisor up to this point, which I 

think is lacking? Did you take into consideration the fact that the 

Fed already has responsibility for monetary policy, bank supervision, and lender-of-last-resort functions? And are you concerned 
30 

about the implications of the fact that, as you noted, the Fed is not 

politically accountable in the way other agencies are? 

I know that is a lot of question, but you are a distinguished professor and you can handle it. 

[Laughter.] 

Mr. COFFEE. Those are all good points. 

Senator SHELBY. Can you bring your microphone up a little bit? 

It is not on yet. 

Mr. COFFEE. The problem is that the Fed is not perfect. It is far 

from perfect. I think it is better positioned than agencies like the 

SEC. The SEC is focused on transparency and enforcement, not on 

prudential supervision, and the second-tier functions of an agency 

are the functions that are most likely to be captured by the industry. 

Also, frankly, there no longer are any investment banks. They 

have all moved someplace else. There is nothing left for the SEC 

to exercise prudential supervision over. Therefore, I have got to 

think we have to start, warts and all, with the Federal Reserve as 

the only body that has this capacity and has the orientation and 

has the competence. It may not always have performed well. 

Your point about political accountability is very important, and 

that is why I keep insisting that investor protection should not be 

subordinated and should be given to a very independent agency, 

the SEC or the SEC/CFTC, because I do not think you can count 

on the Fed with its orientation to ever be a champion of the investor’s rights. The culture is one of secrecy, and you saw this all in 

the AIG. I think AIG is representative of the problems you will 

have if you depend upon the Fed for transparency. But I do not 

think the SEC is going to do much better than it did in the Consolidated Supervised Entity Program. 

Senator SHELBY. Professor Coffee, are you concerned that when 

you identify institutions as too big to fail, that will dull the market 

discipline of those firms which the market will view as having a 

Federal guaranty? Is that a concern always in the marketplace? 

Mr. COFFEE. I am not testifying that every organization should 

be bailed out. I think the ones that most merit this are the ones 

that are so entangled that you get the true problem of systemic 

risk. Systemic risk is the danger of interconnected failures, the 

chain of falling dominoes. I am not telling you whether or not AIG 

should get more money. I am telling you only that where we have 

companies that are too entangled to fail, that is where we most 

need prudential supervision and a Systemic Risk Regulator. 

Senator SHELBY. Mark-to-market accounting, Mr. Turner wrote 

this up and I think he is right. Do you believe the current attacks 

on mark-to-market accounting, Mr. Turner, are motivated by a 

similar understandable desire to avoid taking painful write-downs? 

Mr. TURNER. I think, without a doubt, Senator Shelby, they are 

a problem here. You know, if you make a loan at $100 and you are 

only going to get $70 back, that is OK once or twice, but we did 

it millions and millions of times. The bottom line is they just aren’t 

worth what they were, and to report to the public, to investors, regulators that you have got a balance sheet that is substantially different than what it is really worth is just flat out misleading, if not 

straightforward fraudulent. 
31 

Senator SHELBY. Mr. Ryan, your testimony recommends a Financial Market Stability Regulator that, among other things, would 

have a direct role in supervising, quote, your words, ‘‘systemically 

important financial organizations.’’ What are the criteria, Mr. 

Ryan, that you would recommend for identifying systemically important entities, and do you believe that there would be any competitive implications for firms that are not so designated? 

Mr. RYAN. Thank you for your question. We have given a lot of 

thought to a number of issues, and on some of these issues we do 

not have final decisions. I am talking now within the industry. For 

instance, we spent a lot of time talking about should we recommend the Fed immediately as the systemic regulator, and we 

have not come to that conclusion yet. If we had to do it right away, 

they are probably the best qualified to do it, but we think that the 

industry and the Congress, the American people, deserve a really 

comprehensive view. 

The same is true of who is systemically important. It is pretty 

easy to identify the early entrants because they meet the test that 

Professor Coffee has enunciated. They are too interconnected. They 

are very large. They are providing consolidated services to the citizens of this country and we need a better understanding of their 

interconnected aggregated risks. 

So the first group will be easy. The second group will be more 

difficult because they may not be so interconnected. They may not 

even be that large. But they may be engaged in practices which 

could have a very dramatic impact on our health. 

So our hope would be that we anoint a systemic regulator, maybe 

it is a new entity, maybe it is within Treasury, maybe it is the Fed, 

that we orient them in legislation toward preselection of the people 

who are very obvious, and that we give them the flexibility to include and actually to have people move out of systemically important status going forward. So once you are in it doesn’t necessarily 

mean that you will stay in it. 

I think it is pretty clear, though, we all know the basic early entrants and they are our larger financial institutions. We, by the 

way, would not limit this by charter at all, so there will be banks, 

there will be insurance companies, there will be hedge funds, there 

could be private equity players. It is people who could have a dramatic effect on our lives. 

Senator SHELBY. Professor Coffee, why should we continue to 

prop up banks that are basically insolvent, some of our large banks 

that are walking dead, so to speak, give them a transfusion, and 

there is no end in sight? Why should we do that rather than take 

over some of their—guarantee some of their assets and whatever 

we have to do and wind them down? 

Mr. COFFEE. Again, it is a perfectly fair question and I am not 

telling you that every bank should be bailed out, not even every 

large bank. But if we are going to get the financial system working 

again, we have to move credit through banks. 

Senator SHELBY. Sure. 

Mr. COFFEE. You can nationalize them. There still has to be a 

management. 

Senator SHELBY. I have never advocated that. 
32 

Mr. COFFEE. The government can’t run a bank. It might be that 

if you want to name institutions that may not deserve further bailouts, AIG is an example. It is not a bank and basically the government is spending $160 billion there to pay off the counterparties, 

most of whom are foreign banks. 

Senator SHELBY. Obviously poorly regulated. 

Mr. COFFEE. I am saying that the key bank institutions are the 

only way we can get a corporate capital system moving again. The 

money has to flow through the system, and if they are part of the 

basic transmission belt, then there is a strong argument for ensuring their survival. 

Senator SHELBY. Mr. Ryan, you and your organization, the Securities Industry and Financial Markets Association, have advocated 

a merger of the SEC and the CFTC. You are not by yourself there. 

If a merger, should it go forward, should it occur simultaneously 

with whatever broader regulatory restructuring we undertake in 

this Committee? Should it be part of the overall comprehensive 

structure, restructure? 

Mr. RYAN. I would sort your—because I think the biggest issue 

Congress has right now, you obviously have many, many issues on 

your plate and sorting them by priority is an essential component 

of your work right now, I am sure. So our recommendation is that 

you sort them with the systemic regulator being first and immediately come behind that with cleaning up the many regulatory 

agencies that have overlapping authority. If I was the new regulator, I may actually ask you to do those simultaneously so I would 

know my job. 

May I also—— 

Senator SHELBY. It would send certainty to the market, would it 

not? 

Mr. RYAN. Yes, sir. I think that is possible. May I also just provide one comment based on your last question to the professor to 

my right? 

Senator SHELBY. Go ahead. 

Mr. RYAN. Because I am probably—because I spent an awful lot 

of time in this Committee when I was the OTS regulator—— 

Senator SHELBY. You did. 

Mr. RYAN. ——dealing with the RTC, and what I learned 

through those 3 years brings me to a very firm view on opposition 

totally to nationalization of financial institutions. We have a process in this country through the FDIC where we, in a sense, nationalize. We call them bridge banks. We know that if you put very 

large institutions into bridge banks and they stay there for a very 

long period of time, the cost escalates enormously. You can look 

back to the RTC experiences. If we ask the government to take control of a large financial institution and run them, the cost of resolution is going to dramatically increase. The way we are doing it 

right now is much better. Thank you. 

Senator SHELBY. One last question, Mr. Chairman, if I can, to 

Mr. Silvers. Mr. Silvers, you advocate a greater role for long-term 

investors in the election, I will use your term, of psychologically 

independent directors on corporate boards. What measures would 

you take to ensure, sir, that these directors whose responsibilities 

would flow to all shareholders of the corporation are independent 
33 

not only of management, which is important, but also the shareholder group responsible for their election? 

Mr. SILVERS. Senator Shelby, I think that there are several specific ways of doing that. The first is that those mechanisms, as my 

testimony indicated, need to be tied to a certain amount of tenure 

as a shareholder. I think that is a way of ensuring that it is not 

captive to individuals who are looking for liquidity. 

Senator SHELBY. What do you mean by tenure of a shareholder? 

Mr. SILVERS. Holding, a holding period, that anyone who could 

use such a mechanism would have to be a fairly long-term holder 

so that you ensure that it is not used by people who are seeking 

a liquidity event as opposed to people who are seeking the longterm health of the corporation. 

Second, I think obviously that there needs to be, depending on 

exactly what mechanism one uses, that all discussions in this area 

have required that anyone who used such a mechanism would be 

either by themselves or as part of a group a significant set of holders. Certainly in large corporations, more than 1 percent of the 

shares, and in very large public corporations, it is a very large collection of money, or at least it used to be until recently market 

events. 

And then third, the most important protection here is a very simple one, which is that we are talking about a nomination mechanism, not an election mechanism. The majority of stockholders 

would have to vote for such a person, and the corporation, the management, at least under Delaware law, has the right to use pretty 

much limitless resources to campaign against them. I think that is 

the fundamental barrier. 

Senator Shelby, if you would allow me, I want to say a word or 

two to you about the Federal Reserve in response to your questions 

to Professor Coffee. 

Senator SHELBY. Yes, sir. 

Mr. SILVERS. I believe that the concerns you raise are profound 

and important ones and that they are profound in relation to the 

question of whether we want—the task we are asking a Systemic 

Risk Regulator to take on a fundamentally public task. The Oversight Panel that I serve on its regulatory reform recommendations 

specifically stated, if we are going to ask the Fed to take those obligations on, the Fed must be governed differently. 

I would be comfortable, personally, with that arrangement, with 

a greater degree of accountability and doing away with the self-regulatory aspects of some of what the Fed does. But I am convinced 

that that is probably not the best way to do this, and the reason 

why I am convinced about that is because, A, I am think that the 

Fed—there are tradeoffs with the Fed and the other things we ask 

the Fed to do. And the second reason is because, while I agree with 

Professor Coffee that the SEC is not suited to be the Systemic Risk 

Regulator, that that job is going to—as long as we have a twin 

peaks-type model where information about our markets is flowing 

from different directions within the regulatory system, that that coordination of information and openness to information is critical. If 

we ask one body to take it on, that is going to have an impact on 

the flows from the other bodies. 
34 

The best answer, I think, in light of that is an agency with staff 

that is governed by the heads of our twin peaks or our three peaks. 

I hope we don’t get to 14. How many hundred peaks are we talking 

about, Lynn? 

[Laughter.] 

Mr. SILVERS. But an agency that is governed by the independent 

regulators but has its own staff and mission in this area. And I 

think the Fed would play a very large role there because they 

are—— 

Senator SHELBY. And they can’t be overridden by the Fed? 

Mr. SILVERS. Yes. That is—— 

Senator SHELBY. That is important. 

Mr. SILVERS. I don’t think we can give the power to override fully 

public bodies charged with issues like investor protection to the 

Fed. Thank you, Senator. I appreciate your indulgence. 

Senator SHELBY. Thank you. 

Chairman DODD. Thank you, Senator, very much, and that is a 

question that many of us have raised, given the already full plate 

that the Fed has, in addition to roles they are taking on. The obvious problem is that if you move away from the Fed as the model, 

creating a whole new entity raises another whole set of issues and 

that is the quandary I find myself in. I don’t disagree with Richard 

Shelby’s point. We have all talked about it here at various other 

times. And then I quickly say to myself, so what is your alternative? And when I come to my alternative, I find myself almost 

in as much of a quandary. 

And so we find ourselves in this position of trying to make a 

choice between an existing structure in which I can see how this 

could fit—I think your point, as well—although you would have to 

make some changes in this thing, or trying to create something altogether new, which has also got its difficulties. But it is a very 

critical point, obviously, and one that we are talking about, obviously, at this point. 

Anyway, with that point, Senator Bennet, I thank you for your 

patience. 

Senator BENNET. Thank you, Mr. Chairman. 

I want to start broadly and then ask a couple of narrow questions. Professor Coffee talked about the difference between the culture of the banking regulator and the culture of the securities regulator, which has been a theme that we have heard about in this 

Committee, and in thinking about the new structure, we want to 

make sure that that culture shifts, I think, so that we get the kind 

of oversight that all of us will feel comfortable with. 

In addition to that, there is the issue of no matter what structure 

you have, the constant innovation that goes on in the market and 

having some assurance that the regulator is keeping up with that 

innovation, as well. We want the innovation but we also want to 

make sure we understand it. 

And then Mr. Turner’s observation that what is really critical, as 

it is with all human institutions, is that you get the right people 

in the job, and unfortunately, neither he nor we have the magic 

wand that he called for. 

But I guess the question I have is, are there thoughts from you, 

Professor Coffee or others on the panel, about what we could do in 
35 

this legislation to assure that we have the kind of attention to the 

changes in the market knowledge about approach and the right 

people so that we can really get the job done? 

Mr. COFFEE. First of all, you and Senator Shelby are definitely 

focused on the proper issue. The Federal Reserve may have to 

change. You may have to give it a very different staff, a very different accountability structure. You are certainly going to want it 

to monitor, but I don’t think you can ever make the Fed into a 

strong enforcement agency. I don’t think you could ever make the 

SEC into a strong prudential supervisor. 

What I think you have to recognize is in terms of new market 

developments, the Fed has a more universal view. The SEC, at 

least as it stands today, doesn’t have jurisdiction over swaps, overthe-counter derivatives, or futures. It is not going to know inherently what is going on in those areas. Yes, you could merge the 

SEC and the CFTC, but that compounds the political difficulties of 

achieving our solution by, I think, several orders of magnitude. 

And I would agree with the prioritization model that Mr. Ryan 

just discussed. First create the optimal kind of Systemic Risk Regulator, which may require changing the Fed, changing its accountability structure, giving it a permanent staff that would do the 

kind of monitoring we have in mind. But I think that is the smaller 

change than designing something totally from scratch. 

Mr. STEVENS. Senator, could I comment on that? I know that 

many have not had a chance to absorb it, but I am very struck by 

what Chairman Bernanke had said today, because everyone is talking about his agency, of course, and he says, and I am quoting now, 

‘‘Any new systemic risk authority should rely on the information 

assessments and supervisor and regulatory programs of existing financial supervisors and regulators whenever possible.’’ 

What that means to me is they don’t want to take all these functions aboard themselves. They want a very strong Capital Markets 

Regulator. They want a very strong bank regulator. They probably 

want a very strong Federal insurance regulator that they can work 

with. The notion that they can pull all of that inside the Fed and 

at the same time accomplish their traditional missions is something I think, as I read the speech, and this is more subtext than 

text, is unsettling to the Chairman of the Fed, and with good reason, I believe. 

I would say also in commenting on Chairman Dodd’s quandary, 

and I don’t know if this is useful or not, but I spent a considerable 

period of time as Chief of Staff of the National Security Council 

and I have reflected a lot on that innovation in our government. 

It came online after World War II and our experience as a nation 

of the inability to coordinate and integrate the efforts of our Diplomatic Service, our Armed Forces, and the like at a time when we 

had burgeoning global responsibilities as the superpower in the 

aftermath of World War II. It is a Cabinet-level Council that is 

chaired by the President. It has a staff whose professionalism and 

abilities have been built up over time. And its function is there to 

collect information, to monitor developments, to integrate and coordinate the efforts of government. 

I think it is not out of the question that you could create a similar coordinating mechanism, and I think this is part of what 
36 

Damon is pointing toward, at a very high level with the regulatory 

agencies that would pull all their expertise together, give the chairmanship of it to someone, and maybe that is the Chairman of the 

Fed, give it a permanent staff, and allow it to be monitoring and 

collecting data and doing the analysis, but in conjunction with 

those who are the front-line regulators and whose expertise has got 

to be leveraged. At least that is, I think, a reasonable concept on 

which to reflect. 

Senator BENNET. A completely unrelated question. I didn’t come 

here to ask it, but the Ranking Member asked about mark-to-market and your answer is very clear. This is a place where I have 

gone back and forth. If our markets were lubricated and were doing 

what they were supposed to be doing, we wouldn’t be sitting here 

talking about investing taxpayers’ money the way we are talking 

about investing it to create stability in the market. 

And I wonder whether there are others here that have a different 

point of view on mark-to-market in this sense. It seems to me that 

there is a legitimate distinction between assets that are held by 

these banks that have no collateral behind them or very little collateral and assets that are held by our banks that have collateral 

but simply have no market right now and therefore aren’t trading 

at all. I know there is a pure view that says that should tell you 

that the assets don’t have value, but the thing I keep stumbling 

over is that some have collateral and some don’t have collateral 

and shouldn’t we be taking notice of that? 

Mr. SILVERS. I do not, in general, share Lynn’s complete enthusiasm for mark-to-market accounting. I think that there are a wide 

range of areas in financial accounting where historical cost accounting is actually more indicative of the life of the business than 

mark-to-market. However, the financial institutions, particularly 

those with demand deposits where in theory the funds can walk 

out the door, are ones that seem uniquely kind of attuned to markto-market principles. 

In the course of the work of the Congressional Oversight Panel, 

we have done two oversight—two hearings, two field hearings in 

relation to our mortgage crisis, which I believe and I think most 

economists believe is at the heart of what has gone wrong here in 

our economy, that underlies the financial crisis, and it is clear from 

those field hearings, in P.G. County not ten miles from here and 

in Nevada, that even at this late date, we do not seem to be able 

to get rational outcomes out of private ordering in terms of nonperforming mortgages. We can’t get the mortgage providers and the 

servicers to negotiate rational outcomes with homeowners. 

Now, I believe that this is related to the remnants of non-markto-market accounting in banking, that effectively loans that are 

never going to be worth—the banks are carrying loans that are 

never going to be worth full value, even though they are capped at 

high values maybe not at par, but at close to par. And the one 

thing that would force them to mark them down would be a rational settlement with the homeowner, because then you would have 

to admit what you actually had. 

Now, you asked about collateral. You walk through the subdivisions and not all of them are new. In P.G. County, you have got 

a lot of people who have been effectively exploited and stripped of 
37 

their homes. That is Prince George’s County, for those who are not 

Washingtonians, here in Maryland. You look at those properties. 

There may be collateral, but it will never support par value, never. 

It may return—it may recover value. It may, 10 years from now, 

if the last very serious real estate collapse is indicative, and I am 

afraid this is clearly worse, in many areas, it took 10 years to recover from the bust of the late 1980s and early 1990s. But returning to par in 10 years means you are never really worth par 

present value basis, you are not going to be there. 

And so I am in favor of sort of—I am kind of in the middle of 

the road on these issues, but I think we need to recognize that 

there could be very, very serious broad economic consequences of 

indulging the fantasy that subprime loans backed up by collapsed 

residential property are ever going to be worth par. They are just 

not. And the consequences of that pretense is actually throwing 

people out of their homes. 

Senator BENNET. Mr. Chairman, could I ask one more quick 

question—— 

Chairman DODD. Certainly. 

Senator BENNET. ——for Mr. Doe. I was very interested in your 

testimony. This is a line of conversation that Senator Warner and 

I have been having. I assume that your view is that there is Federal authority now to be able to intercede, either through the 

Treasury or the Fed, with the VRDO market in some way that may 

give hospitals, public hospitals, schools, and other municipal credit 

some relief from the lack of market that exists for variable rate 

debt—— 

Mr. DOE. Well, I think one of the key issues associated with that 

is that many of the issuers that have—that are confronted now 

with challenges of restructuring their debt in the variable rate 

market, as I pointed out in my testimony, these variable securities 

have links to interest rate swaps which have created all sorts of 

issues. And one of the things that these—the cost of termination 

of the swap transaction has become overly penal, and in some of 

these small towns and counties where it is arguably there was a 

mismatch in terms of appropriateness. And again, remember that 

the regulatory body of the municipal industry doesn’t have purview—has limited purview, only on dealers and only on cash securities. So here you have these cash transactions linked to swaps. 

It makes it a little bit of a conundrum. 

But one of the things we think where the Treasury could step in 

and make a big impact is to provide subsidized loans to municipal 

issuers that would help them terminate those swap transactions, 

and then over time, the cost of those loans could be recouped in future transactions and discriminate fee, and I think that would be 

a really important step. So I think those are the people and the institutions that have been most adversely impacted. 

Senator BENNET. I would like to thank the witnesses for their 

testimony. 

Thank you, Mr. Chairman. 

Chairman DODD. Thank you very much. 

Senator Reed. 

Senator REED. Well, thank you very much, Mr. Chairman, and 

thank you, gentlemen, for excellent testimony. 
38 

Just as two preliminary points, first, I want to thank Professor 

Coffee for his kind words about our credit rating legislation. Thank 

you very much and thanks for your help. 

And then to Mr. Turner’s point about the need for resources regardless of what we do, this omnibus we are debating contains an 

additional $38 million for the Securities and Exchange Commission 

and the proposed budget of the President is around a 13 percent 

increase over the 2008 marks going forward, so I completely concur. We can make all the structural and legislative changes in the 

world, but if they don’t have the resources and the will to do the 

job, it won’t get done. 

One of the impressions I had listening to your comments is that 

I think we were in this sort of false logic where regulators of all 

ilk were looking at the capital of institutions, saying we don’t have 

to be too sensitive to their risk evaluation assessments because 

they have got capital. Of course, the capital was risk-based, so you 

are in this circle around where if you don’t do a good job evaluating 

capital based on risk, then you don’t have the capital, et cetera. 

Part of this goes to Basel, the efficacy or the effectiveness of 

Basel. I think that has to be looked at. 

And the other issue I think has to be looked at, too, is just the 

managerial capacity to run these organizations. I think one of the 

issues of size is do you really have the wherewithal, the computer 

systems, the structural managerial skills to run them? 

This is a long sort of preface to be saying that it appears that 

this, in my view, twin peaks model we will probably adopt in some 

form, that by default, perhaps the Federal Reserve will become the 

regulator, and unless we make some significant changes in the culture and the operating standards of the Federal Reserve, we might 

be exactly where we were before, that this sort of just looking at 

risks—not looking at risks, not looking really well at management. 

So I don’t know if you have comments, Professor Coffee and gentlemen? 

Mr. COFFEE. I think that is the danger. I think you are correct 

and I think it does justify what I think Senator Shelby was going 

for, some modification of the charter and the requirements and responsibilities of the Federal Reserve. I think the best way to protect transparency is to make sure that the SEC’s authority to require full disclosure is not circumscribed. But I do think that we 

are now in the world where the price of all bank stocks has fallen 

so low, with Citicorp trading at $1.50, this is the time to pursue 

mark-to-market because the market doesn’t believe these banks 

have any value. You might as well bring the accounting in accord 

with the reality as the market reflects it. 

I think your concern is that changes in the Federal Reserve is 

a sound concern, and I can’t tell you, because I am not a Federal 

Reserve expert, of what the five things I would do first to the Federal Reserve are. 

Senator REED. Does anyone else want to comment? Mr. Ryan? 

Mr. RYAN. We have been talking about resources, and many of 

the panelists have talked about whatever changes we make here, 

let us make sure that we have the right people doing the job, that 

they have adequate resources. 
39 

One specific topic I think deserves the Committee’s attention and 

Congress’s attention is whoever is going to do this job has to have 

the technology resources to get the job done, because when we ask 

someone to be the systemic regulator for our most important financial institutions, we are also, I think, asking them to do a job that 

regulators have not really done well at all, which is to look over 

the horizon. They are pretty good at looking back and looking at 

what went wrong and let us see if we can fix it. But we are going 

to ask this new entity or the Fed to do a job that we have not really done before and they need to have the tools to do it. 

They really need to think about the technology demands, because 

right now, we do not have a full understanding of the aggregated 

or collective risks of all of these interconnected entities. We have 

the capacity to do it from a technology, hardware, software standpoint, but we don’t really have that done. It is going to be very expensive and it is very important that you spend some time on that. 

Senator REED. One of the points I would note is that when 

Chairman Donaldson became Chairman of the SEC, he tried to establish a risk assessment operation. That initiative was undone by 

his successor. But I think we should consider along those lines, Mr. 

Ryan, requiring the systemic regulator to have a rather independent risk assessment group that on a periodic basis will publish 

to the Congress and to the people what they consider to be the 

most significant pending risk and the likelihood. That might force 

discussion and maybe even sometimes action. 

Professor Bullard, and then Mr. Silvers and then Mr. Turner, 

and then I have one last point. 

Mr. BULLARD. I just wanted to add that, again, to me, the systemic risk question is one of someone who has oversight over a 

range of prudential regulatory regimes. The Fed already is our systemic regulator. It may not have that aggregated information as 

Paul was talking about, but it has the discount window, it has the 

open market transactions, it has the ability essentially to create 

money, although the Treasury has shown remarkable ingenuity in 

creating money recently, as well. 

So it already serves in that role. I think it is a separate question 

as to as it sits back and decides where it needs to take action to 

affect credit markets, it sees some hot spots over here with respect 

to the support for some area, that it also should not necessarily be 

expected to be the prudential regulator that is in charge of monitoring what stands behind that particular area of our financial 

services, because those really are separate functions. 

The systemic regulator is one who can go in and fix it with ultimately taxpayer dollars and then tries to find situations where it 

can mitigate that risk and reduce it. The prudential regulator is 

the one who writes the rules that says, to back these kinds of liabilities, these are the kinds of assets we expect you to have, and 

I am not sure that those are necessarily ones that should be or 

have to be housed in the same agency. 

Senator REED. Mr. Silvers, then Mr. Turner, then I have one 

final unrelated question. 

Mr. SILVERS. Senator Reed, first, I share your concerns about 

Basel II. I think that is clearly part of the causal fabric here for 
40 

our crisis. There are three points about the sort of managerial and 

task challenges associated with systemic risk regulation. 

First, the Congressional Oversight Panel in its regulatory reform 

report suggested that the notion of intelligence, of looking over the 

horizon in relation to financial market systemic risk, should perhaps be delegated not to a regulatory body but to a panel of outside 

experts—some of my fellow panelists here might make good members of such a panel—whose sole job was to look ahead and that 

were not intertwined in the politics of the regulatory landscape. 

Second—and this is a concern that Senator Shelby raised—our 

view was it would be a very bad idea to name who is systemically 

significant. In fact, it is not only a bad idea in terms of moral hazard, but it is actually impossible to do; that in a crisis people will— 

institutions will turn out to be systemically significant that you 

had no idea were. And Exhibit 1 for that is Bear Stearns. 

And there are other times, calm times, when very large institutions may be allowed to fail, and probably should be; and that rather than naming institutions, we ought to have the capacity—and 

this comes to your point—the capacity for the systemic risk regulator to work with other regulators to set ratchets around capital 

requirements and around insurance costs to discourage people getting essentially too big to fail and to set up the financial basis to 

rescue them if they do. 

Finally, there is, I think, some—I am not a Fed expert, but I 

think there is some confusion about where the money comes from 

for bailouts and rescues and so forth. The Fed does not have the 

authority, as far as I know—although you all maybe can educate 

me. The Fed does not have the authority to simply expend taxpayer 

dollars. The Fed lends money. It is the lender of last resort. 

In a true systemic crisis, as we have just learned, we get beyond 

the ability of liquidity to solve the problem, and in that circumstance we start expending taxpayer dollars. 

It is hard not to look at the TARP experience and what preceded 

it and not conclude that the ad hoc quality of those experiences did 

not build public confidence or political support for what had to be 

done. 

Given all of that, I think we need to understand that when we 

ask a body to take on the role of systemic risk regulator, that also 

means we are asking them to take on the role of rescuer, and potentially to expend taxpayer dollars. And that I think requires a set 

of governance mechanisms and capacities, to your question, Senator, that we have yet really to build. And it also requires, I think, 

a careful balance between genuine public accountability and transparency, on the one hand, and genuine independence from the all 

too eager desire of everyone around to bail out their friends. 

Senator REED. Mr. Turner, do you have comments? 

Mr. TURNER. Just like Damon, I would say Basel II needs to be 

re-examined. I expressed concern almost 8 years ago to the Fed 

that it would not work, and I think if it stays the way it is, it will 

contribute to further problems. I think Sheila Bair has been very 

insightful on that in that regard. 

As far as managing the risk, I have actually had to run a large 

international semiconductor company, and in the technology area, 

we had a lot of risk, and it changed very dramatically, much faster 
41 

than what it even does in the banking industry. And what we 

found was, if we are going to be successful in managing the risk, 

we could not do it with the same people that we had necessarily 

running the operational, the manufacturing side of the company. 

You needed a group of people that were much more focused on the 

future and where things were going. They needed to be looking not 

just ahead, but much further ahead, and have a pulse not only 

what was going on but where that turned around and took you. 

After Donaldson formed the Risk Management Office, I went and 

visited with him for a while. Certainly that type of mentality plus 

the tools were not in that group at that point in time. I have not 

seen that at the Fed in my dealings with the Fed over the last couple decades either. 

I am not sure you can get that without a major wholesale 

change, and so I come back to—having gone through this and having to manage risk myself, I come back to probably what Damon 

has said, and probably the best way to put this together across the 

broad spectrum would be to create the separate organization, 

chaired with the board of the major chairmen of the major agencies, but with real staff and real resources and focused on that aspect of the business. I just do not think we are going to get it if 

you put it inside one of these agencies. 

And, in fact, think about it. We have had risk management—a 

Risk Management Office in the Fed, in the OCC, in the SEC, and 

it has not worked. And why would we turn around, given what this 

devastation and travesty has cost us all, why would we go back and 

say let us try it again? You know, this is not one where I give people another swing at the bat. 

Senator REED. Mr. Chairman, you have been very kind. I have 

one question, if I may. 

Chairman DODD. Sure. 

Senator REED. I will address it to Professor Coffee, because it 

might be way off the beaten track. In fact, it sounds like an extra 

credit question in a law exam. 

[Laughter.] 

Senator REED. So here it goes. Whatever happened to Rule 10b5? I mean, I have been listening to discussions of potential fraud 

in the marketplace, securities that had no underlying underwriting. And I grew up thinking that material omissions as well as 

material commissions gives the SEC in every capacity, as long as 

it is a security, to go in vigorously to investigate, a private right 

of action, and yet I have been before the Committee now for 2 and 

3 years, and I do not think anyone has brought up, you know, Rule 

10b-5 actions. Can you just sort of—— 

Mr. COFFEE. I am glad you asked that question because it is a 

good question, but there are two major limitations on Rule 10b-5. 

As you have heard from others on this panel, it does not apply to 

aiders and abetters, even those who are conscious co-conspirators 

in a fraud. That is one limitation that Congress can address. And, 

two, when you try to apply Rule 10b-5 to the gatekeepers, whether 

it is the accountants or the credit rating agencies, you run up 

against the need to prove scienter. It is possible to have been stupid and dumb rather than stupid and fraudulent, and that is basically the defense of accountants and credit rating agencies. 
42 

I think you need to look to a standard of scienter that will at 

least create some threat of liability when you write an incredibly 

dumb AAA credit report on securities that you have not even investigated, because you do not do investigations as a credit rating 

agency. You just assume with the facts that you are given by management. 

So I do think there is some need for updating the anti-fraud 

rules for the reasons I just specified. 

Senator REED. Thank you. 

Chairman DODD. Senator Warner. 

Senator WARNER. Thank you, Mr. Chairman. A fascinating panel. 

First of all, I commend you for asking that ‘‘What is the one takeaway?’’ question from each of these gentlemen. And while I think 

there was a consensus that we need to get rid of this shadow market, we need to make sure we get rid of this Swiss cheese approach 

to regulation, I think we will be challenged, taking some of these 

broad overviews and taking them into specific legislation. 

Chairman DODD. I agree. 

Senator WARNER. And I appreciate your asking that question. 

I want to follow up, before I get to my quick question, on Senator 

Shelby’s comments along the notion of the institutions that have 

posed this systemic risk, the ‘‘too big to fail’’ excuse, and Damon’s 

comments about perhaps not publishing those that are systemic 

risks, but this problem we are in the middle of the crisis now of 

too big to fail. And I would be curious perhaps in a written question to the Members—I know Senator Shelby has, I think, provocatively raised a number of times the issue of, well, how much more 

on Citi and should we go ahead and let it go through some kind 

of process? And the quick response normally being, well, no, that 

is too big to fail. 

Well, I would love to hear from the panel, perhaps in written testimony, if you were to see the transition, dramatic transition—and 

I know we are sometimes afraid of the terminology, whether it is 

‘‘receivership’’ or ‘‘nationalization,’’ some other way to get it out of 

the current ditch that it is in—you know, how you would take one 

of these institutions that fall into this ‘‘too big to fail’’ category that 

appears to have real solvency issues and get it through a transition? And I perhaps would work with the Senator on submitting 

that type of written question. 

So we have seen, you know, the big take-aways on how we regulate and where we put this prudential or systemic risk oversight. 

We have seen the question of how we deal with the current challenging institution. I want to come with my question, and I know 

our time is about up, but I will start with Mr. Pickel, but would 

love to hear others’ comments on this, and that is, maybe come at 

this from the other end. 

Even if we get the risk right, with the great people that Mr. 

Turner has advocated, where and how should we look at the products? I would argue that intellectually I understand the value of 

derivatives and the better pricing of risk. I candidly would love 

somebody to say, How much societal value have we gained from 

this additional pricing of this risk when we have seen all of the 

downside that the whole system is now absorbing because, to use 
43 

your terms, you know, actions by AIG and others of misunderstanding of the products and not taking appropriate hedging? 

I guess I have got a series of questions. How do we prevent the 

current products or future products from being abused? Should we 

have standards whereby if an AIG, a future AIG, either misunderstood or went beyond protocols, that that would set off more than 

an alarm bell and would require some kind of warning? Is it simply 

enough to say we are going to move toward some level of a clearinghouse? Is clearing alone enough security? As some of the European regulators have talked about for those products and contracts 

that do not go through a clearinghouse, should there be needs of 

additional capital requirements? 

You know, I am all for innovation, but in some cases I think 

under the guise of financial innovation and financial engineering, 

we have ended up with a lot of customers, including customers that 

Mr. Doe represents in terms of some of the muni market, getting 

in way over their head. And I just fear on a going-forward basis 

that regulation and transparency alone may not solve the problem. 

So rather than coming at it at the macro level on regulation or 

on the specific issues that I think Senator Shelby has wonderfully 

raised about how do we unwind one of the ‘‘too big to fail’’ institutions, I would like to look at it from the bottom up on the products 

line, starting with Mr. Pickel and then anybody else can comment. 

Mr. PICKEL. Yes, I think as far as the products themselves, if you 

look, for instance, at the credit default swap market, there is information that has been published by the Depository Trust and Clearing Corporation through their trade information warehouse, which 

encompasses 80 to 90 percent of credit default swaps engaged in 

around the world. And the information there is that virtually all 

the trades in that warehouse, essentially all, 100 percent, are done 

involving at least one dealer party who is, in fact, a regulated institution, and actually 86 percent of them are between two dealer institutions. So you have got that structure of the institutional regulation there, of the oversight of those individual firms looking at 

the activities of those firms. And I think the Committee, again, 

heard testimony from the OTS last week admitting some shortcomings in their enforcement and in their execution of their authority, but perhaps we should look at making sure that they have 

got the ability to understand and get more detail on the products 

that those individual entities are—— 

Senator WARNER. Just a quick question, Mr. Pickel. But those 86 

percent of institutions that are involved in using these products, 

are you saying the market knows all the terms and conditions and 

that we have got a transparent market there? 

Mr. PICKEL. The parties who engage in those transactions have 

access to information and have the transparency to engage in those 

transactions. I think you also have regulators who have the authority—whether they have exercised it and what they have done with 

that, we should discuss further. But they have the authority to understand what those institutions are doing. 

I think the other thing is—and we have got a very good example 

of this in the credit default swap market, an effort that goes back 

to September 2005, started by now—— 
44 

Treasury Secretary Geithner, to pull in the regulators in a global 

initiative, regulators from around the world, as well at that time 

18 major credit default swap players, dealers, and also buy-side entities as well, to talk about issues that were serious and needed to 

be addressed in the credit default swap market at that time. And 

significant progress was made very quickly, with the implicit 

threat—or, actually, explicit threat, I think, from the regulators, 

that if you do not get your act in order on these backlogs and assignment issues, that they will actually stop people from trading. 

So the regulators indicated that they would take that action, and 

the industry responded. 

The experience that we have gone through in settling credit default swaps over the past 6 to 8 months has been significantly facilitated by the foresight of Secretary Geithner at that time to anticipate these problems. So that was an important step at that 

time. 

So I think looking at those kind of public-private interactions 

where regulators and the industry work together to identify these 

issues is very important going forward as well. 

Senator WARNER. Mr. Stevens, I would love to hear from you, 

Mr. Ryan, and Mr. Silvers. 

Mr. STEVENS. Thank you, Senator. I think it is a really excellent 

question, and I have asked myself this, and it is not intended as 

a competitive observation. 

If Franklin Roosevelt were to come back today and he would find 

we had these enormous pooled funds that were outside, virtually 

outside of any form of regulation, I think he would say, ‘‘I thought 

we solved that problem in 1940.’’ 

We need to make sure that the evident developments—and these 

are not secrets—the evident developments, major developments in 

our capital markets are addressed as they arise. Hedge fund investing is no doubt a tremendous innovation that can be of great 

value. But there were trillions of dollars in hedge funds that had 

no form of regulation. I think that is something that Congress was 

aware of, certainly the SEC was aware of. 

You could say the same about the major pooled funds in the 

money markets that will be part of the subject of our report when 

it is issued. Money market mutual funds are about a $4 trillion 

intermediary, but we’re only about a third of the money market, 

which has many other pooled funds. 

So I think it is a problem—and this is how I envision it—of making sure that the capital markets regulator is staying even with 

market developments, and that is going to require not only 

nimbleness at a regulatory level, but, frankly, Mr. Chairman, it requires—it puts a burden on Committees like yours, because in 

many instances it is going to require the tough work of closing regulatory gaps, providing new authority, and even providing new resources. 

I do not think, however, that the answer, Senator is creating a 

new agency that only looks at products, because those products 

arise and exist in the context of a larger marketplace, and they 

need to be understood in that context. 

Senator WARNER. Mr. Ryan. 
45 

Mr. RYAN. Bob Pickel and I have basically overlapping membership. He is very domain oriented, very specific to derivatives, and 

we are basically almost all of the other products and oversight. 

We have spent a lot of time, I would say, over the last 6 months 

trying to figure out what should we be recommending for a new 

regulatory structure. And I would say it is a uniform view among 

the core members of our group and of his group that we feel comfortable recommending a systemic risk regulator that would have 

no real limits on their authority. So they would have all markets, 

they would have all market participants who are significant. It 

would not make any difference of their charter, so it could be a 

bank, it could be an insurance company, it could be a hedge fund. 

And included therein would be their authority to deal with, for instance, derivative products. 

So we can see that there is a lack of confidence in the system. 

There is a lack of confidence among Members of this Committee, 

Members of Congress, members of other statutory developing entities around the globe, and we need to address that. 

So our first attempt at this is to say let us do it through the systemic regulator. Through the systemic regulator, we will also expand the activity, expand the breadth and depth of what is done 

from a regulatory standpoint to cover areas that have been discussing during this panel, some of the stuff that Paul has raised. 

That is the best way to do it. 

We are also going to, in a very early phase, be able to address 

most of the key issues and do it in a thoughtful manner. 

Senator WARNER. Mr. Silvers and Mr. Doe. 

Mr. SILVERS. Senator, these are very acute observations you have 

made about this set of questions. 

First, I am pleased to see that a moment of disagreement has 

emerged. My colleagues on the panel who wish to put the burden 

of regulating unregulated markets, like hedge funds and derivatives, on the systemic risk regulator are, in my opinion, making a 

grave mistake. What we need is routine regulation in those areas. 

That is what closing the Swiss cheese system is about, is routine 

regulation, not emergency regulation, not, you know, looking at will 

they kick off a systemic crisis. Just an observation about that. 

I think that the Fed’s refusal to regulate mortgages was rooted 

somehow in the sense that consumer protection was a kind of— 

something that was not really a serious subject for serious people. 

It turned out to be, of course, the thread that unraveled the system. I think that we should learn something from that. 

When we talk about routine regulation in these areas, I think to 

your question, we have got to understand that it is more than one 

thing. For example, a credit default swap contract is effectively a 

kind of insurance. And if someone is writing that insurance, they 

should probably have some capital behind the promise they are 

making. That is what we learned not just in the New Deal but long 

before it about insurance itself, which was once an exotic innovation. But we learned we had to have capital behind it. 

But that is not the extent of what we need to do. If, for example, 

there are transparency issues, there are disclosure issues associated with these kinds of contracts, for contracts in which public securities are the underlying asset, it is clear that we need to have 
46 

those kinds of disclosures, because if we do not, then we have essentially taken away the transparency from our securities markets. 

Now—two final points. One, derivatives and hedge funds have 

something profound in common. They do not have any substantive 

content as terms. They are legal vehicles for undertaking anything 

imaginable. You can write a derivative contract against anything. 

You can write it against the weather, against credit risk, against 

currency risk, against securities, against equity, against debt. It is 

just a legal vehicle for doing things in an unregulated fashion. 

A hedge fund is the same thing. The hedge fund is not an investment strategy. It is just a legal vehicle, and it is a legal vehicle for 

managing money any way you can imagine, in a way that essentially evades the limits that have historically been placed on bank 

trusts and mutual funds and so on and so forth. 

What is smart regulation here is not specific to those terms. It 

is specific to those activities. It is specific to money management. 

It is specific to insurance. It is specific to securities. And that is 

why it is so important that when we talk about filling these regulatory gaps, we do so in a manner that is routine, not extraordinary. 

Thank you. 

Mr. DOE. Senator Warner, if I could just offer an example, I like 

Mr. Silvers’ comment about the subject of regulation being routine, 

because I think that brings vigilance. Let me give you just a quick 

example of why when I hear you ask the question about products, 

why I think that is so important. 

After the Lehman bankruptcy in September, on the Wednesday 

following there was a liquidation, an unannounced liquidation by 

a money market fund of substantial holdings of cash-equivalent securities which had been created in the municipal market through 

leverage programs and which were used—essentially synthetics securities, so derivatives. 

The liquidation, unannounced—again, a trying time in the market in mid-September—resulted in the following day of there being 

no liquidity in the municipal secondary market, where one transaction that occurred in a distressed situation resulted in the repricing of the entire holdings of investors that were in mutual funds 

that were in individual holdings. 

We estimated that, in a back-of-the-envelope kind of way, about 

$5.5 billion were lost on that September 18th, solely because an illiquid market, because of liquidation of a cash security that was 

synthetic in order to fulfill the needs of having short-term investments for these money market funds, is that created a crisis in confidence that—and a confusion among investors as to what was the 

security of the credits of the States, of the towns that were, you 

know, issuing municipal debt. And that type of concern—and that 

lasted through September and October, and municipal issuers who 

were trying to come to market and raise important funds for capital projects and for operations were really inhibited by extraordinarily penal rates. 

So here we had this, you know, single event and this cascaded, 

touching upon cash securities, derivative securities, and then also 

tied to the supposedly the most secure cash equivalents in these 

money market funds. 
47 

The other thing I think is really important and not to be lost 

here, as we are talking about cash securities, we are talking about 

derivatives, and a lot has been talked about credit default swaps, 

the municipal market, predominantly it is interest rate swaps. 

Here, again, there is not transparency. And yet these are linked intimately with cash transactions. And when we talk about, gee, the 

taxpayer is coming in and helping to bail out the various transgressions that have occurred in the banking system or in the financial system is that here we have taxpayers—and I think, Senator 

Shelby, you had some instances with some derivatives in your 

State that are getting a lot of headlines. And taxpayers are on the 

hook most directly right there. And I would argue and suggest to 

you the notion of really examining this opportunity that we have 

in our U.S. municipal bond market, where all these products have 

come to roost, and the credit default swap market is emerging. It 

is in its nascent stage in the municipal bond market. Yet it is 

there, and it is creating perhaps a thinness or an illiquid market 

that those derivative products is maybe creating misconceptions 

about the soundness of our States and our towns and our counties. 

And so I think that when we start looking at how do we gain 

transparency on these securities that are now part of the risk management of our municipalities and how do we help so we can understand them, so we can see them, so investors that are putting 

their—are facilitating the borrowing by buying these securities, 

they can see what is going on, and we can also help to protect these 

issuers who, as Mr. Turner was saying—well, as we were talking 

about broadly in this financial regulation of the separation of risk 

management and operation, is that here we have these—our States 

and our towns and counties that are serving—wearing both hats 

and using complex securities that they may not have fully understood. 

So I guess when I hear you talk about products, I applaud that, 

because I think that it just cannot be the people involved. We have 

to look at what is being used, but also being—the word has been 

used—‘‘nimble’’ so that we can adapt regulation and be flexible so 

that as new innovations come in that can be very positive but also 

can be seen and understood. 

Senator WARNER. And I think our time has expired, and my only 

last comment would just be that I think we will get to some stance 

where we will have some level of regulatory oversight. My hope is 

that we will adhere to Mr. Turner’s suggestion that it is a nimble 

and well-funded regulator. 

But I would say from the industry, we are going to need your 

help on setting standards not just retrospectively but prospectively. 

With the complexity and financial engineering that goes on, I just 

do not want to be here 5 years later looking at what the next round 

of new products would be and say, ‘‘Why didn’t we see that ahead 

of time?’’ and helping us see what those standards—so that you do 

not end up with having to pre-clear every new product at some regulator. You know, you are going to have to really step up on this 

one and give us some assistance. 

Thank you, Mr. Chairman. 

Chairman DODD. Well, thank you as well, Senator Warner. Very 

good questions. 
48 

Before I turn to Senator Shelby for any closing comments or 

questions he has, I am struck by a couple of things. It is exactly 

the point that Senator Warner was concluding with. There is this 

debate about whether or not we have a principle-based system or 

a rule-based system in the country. And I have always felt I was 

sort of in a small, tiny minority that is attracted to the principlebased system for the simple reason that it seems to me almost in 

a way a bit more intimidating than a rule-based system for the 

very reason that Senator Warner suggested, that you end up setting standards or rules, and within a matter of literally hours, in 

some cases, very creative, imaginative people can come up and figure out some way just to get around that rule, legally and ethically 

and every other reason. And so you are back at it again because 

someone has come up—now, I think the idea of a clearinghouse 

makes a lot of sense, by the way, new product lines, and I know 

Senator Shelby feels as strongly as I do about that. 

But that in itself sort of is an indication of a problem you have 

with a rule-based system, and I wonder if just quickly any of you 

have any quick comments on a rule-based versus a principle-based 

system that you would care to share at this point. Professor Coffee. 

Mr. COFFEE. Well, I have written a long article on this that is 

currently posted on SSRN. I do not think any workable system can 

exist without being a combination of both. You need the principles 

to backstop the rules, but you can really only enforce rules, and 

particularly in our litigation-oriented system, we want rules that 

let you know you are within the safe harbor and you have done 

what you are supposed to do. 

So I think there has to be a combination of both with principles 

backstopping the rules. 

Chairman DODD. Yes. Anyone else want to comment on that? 

Mr. TURNER. Senator Dodd, I would agree with Jack on this one. 

First of all, you know, if you look at the Ten Commandments, half 

the people tell you they are principles, half them tell you they are 

rules. 

[Laughter.] 

Mr. TURNER. So I am not sure anyone knows really what a principle or rule is. I think it does take a combination. Principles get 

so broad that you just never get enforcement. Rules get so detailed 

that people just skirt around them. So it takes some common sense 

and a combination. 

Chairman DODD. Mr. Silvers, do you have a comment you want 

to make? 

Mr. SILVERS. Only that one of the reasons why this discussion 

has become sort of hard to follow or hard to understand is because 

the concept of a principles-based system became code, became a 

code word for a weak regulatory system. 

Chairman DODD. Yes. 

Mr. SILVERS. And, in reality, a true principles-based system 

would be the strongest possible regulatory system, but it would be 

one no one could live in for the reasons that my two colleagues on 

the panel have outlined. 

Chairman DODD. Yes. 

Mr. PICKEL. I would agree in general that we prefer a principlesbased approach. There may be certain circumstances such as with 
49 

retail investors where having clearer rules for those who engage in 

those markets would be appropriate. But for the markets that I 

think people are engaged in derivatives, in OTC derivatives, I 

think the principles approach is the best one. 

Chairman DODD. Yes. 

Mr. BULLARD. I would just add, putting on a private practice hat 

for a moment, that principles-based regulation is intimidating, as 

you described, because what it means is that regulators have enormous enforcement discretion, and what you typically have, at least 

at the SEC, it means that they play ‘‘gotcha’’ and bring cases that 

are based on specific rules that are made up under those principles 

as opposed to opposed to having known ahead of time exactly how 

the SEC might interpret certain positions. 

Chairman DODD. Senator Shelby. 

Senator SHELBY. I will be brief. Mr. Chairman, thank you for assembling this panel. We could be here all day and probably learn 

a heck of a lot. 

Principles matter, but rules matter, too. I like the idea of what 

Professor Coffee is saying. We might need a hybrid in some way. 

If you just have principles and no rules, you know, gosh, who is 

going to define them to a certain extent? But just rules, people say, 

‘‘Well, we have got a rule. How can we get around it? How can we 

evade it in some way?’’ 

So maybe it is a combination. Who knows? But thank you for 

your input, and, you know, we have an awesome task ahead of us 

here. We have got to do this right. We cannot rush to it. We have 

both met with the President on this and many meetings. It has got 

to be comprehensive. It cannot cover every contingency. But I think 

we can do better than we have been doing. 

I wish my friend Senator Warner was still here, because we 

agree on a lot of things, but some of the product approvals, some 

of these products have got to be approved before they do irreparable damage to, I think, the marketplace myself. 

Thank you, Mr. Chairman. 

Chairman DODD. Thank you, Senator Shelby, and again, you 

have been a terrific panel and offered some wonderful advice. We 

will probably submit some additional questions for you over the 

coming days, and we look forward to your continuing involvement 

with us. We have a formal setting here, but my intention is to also 

have some informal settings with interested members here and 

other members who are not on the Committee, necessarily, who 

would like to be a part of the discussion as we move forward on 

this, because there is a growing interest, obviously, not just on the 

part of this Committee but others who care about this issue and 

are interested in how we proceed. 

So I am very, very grateful to all of you for your knowledge, your 

background, your experience, and the thoughtfulness with which 

you have prepared your testimony today and contributing to this 

very, very difficult task. 

Let me just say as well how much I appreciate Senator Shelby 

and the other Members of the Committee. Always from time to 

time we have our differences, but Senator Shelby has made the 

point and I make it as well: This is one where the barriers that 

we traditionally see along political lines have to really evaporate 
50 

and disappear. I personally have said I am agnostic on the question 

of—I do not bring any ideological framework whatsoever to this. I 

want to do something that works, that closes gaps, that does not 

have that Swiss cheese look to it where people can forum shop, in 

a sense, in order to avoid the regulatory process, to make sure we 

have good people who are being adequately compensated for the 

jobs that they are doing, and then doing what has to be done, is 

engaging on a consistent basis. These things are never done forever. There are always new products, new ideas, new—which is the 

genius of this in many ways. That is not a liability. That is an 

asset, in a sense. I have often said our goal here is to, one, make 

sure that we have a solid, sound system that reflects the times we 

are in, but not so rigid that it in any way strangles the kind of creativity and imagination that has drawn the world and others to 

come here to make their investments, because we are creative and 

imaginative. But at the same time, we do not want to be at such 

creativity and imagination that we lose the kind of protections. 

Striking that balance is never perfect. It is never perfect. It is always tilting one way or the other. And our job is to constantly try 

and keep that balance, if we can, as we go forward. And that is the 

challenge we have in front of us, and so we welcome your involvement and thank you immensely for your participation. 

The Committee will stand adjourned. 

[Whereupon, at 1:16 p.m., the hearing was adjourned.] 

[Prepared statements and response to written questions supplied 

for the record follow:] 
51 

1See John C. Coffee, Jr., Joel Seligman & Hillary Sale, SECURITIES REGULATION: Cases 

and Materials (10th ed. 2007) at 10. 2See Rule 15c3-1 (‘‘Net Capital Requirements for Brokers and Dealers’’), 17 CFR §240.15c3- 

1. 

PREPARED STATEMENT OF JOHN C. COFFEE, JR. 

ADOLF A. BERLE PROFESSOR OF LAW, 

COLUMBIA UNIVERSITY LAW SCHOOL

MARCH 10, 2009 

ENHANCING INVESTOR PROTECTION AND THE REGULATION OF SECURITIES MARKETS

‘‘When the music stops, in terms of liquidity, things will get complicated. But as 

long as the music is playing, you’ve got to get up and dance. We’re still dancing.’’ 

——CHARLES PRINCE, CEO OF CITIGROUP

Financial Times, July 2007 

Chairman Dodd, Ranking Member Shelby, and Fellow Senators, I am pleased and 

honored to be invited to testify here today. 

We are rapidly approaching the first anniversary of the March 17, 2008, insolvency of Bear Stearns, the first of a series of epic financial collapses that have ushered in, at the least, a major recession. Let me take you back just one year ago 

when, on this date in 2008, the U.S. had five major investment banks that were 

independent of commercial banks and were thus primarily subject to the regulation 

of the Securities and Exchange Commission: Goldman Sachs, Merrill Lynch, Morgan 

Stanley, Lehman Brothers, and Bear Stearns. Today, one (Lehman) is insolvent; two 

(Merrill Lynch and Bear Stearns) were acquired on the brink of insolvency by commercial banks, with the Federal Reserve pushing the acquiring banks into hastily 

arranged ‘‘shotgun’’ marriages; and the remaining two (Goldman and Morgan Stanley) have converted into bank holding companies that are primarily regulated by the 

Federal Reserve. The only surviving investment banks not owned by larger commercial banks are relatively small boutiques (e.g., Lazard Freres). Given the total collapse of an entire class of institutions that were once envied globally for their entrepreneurial skill and creativity, the questions virtually ask themselves: Who failed? 

What went wrong? 

Although there are a host of candidates—the investment banks, themselves, mortgage loan originators, credit-rating agencies, the technology of asset-backed 

securitizations, unregulated trading in exotic new instruments (such as credit default swaps), etc.—this question is most pertinently asked of the SEC. Where did 

it err? In overview, 2008 witnessed two closely connected debacles: (1) the failure 

of a new financial technology (asset-backed securitizations), which grew exponentially until, after 2002, annual asset-backed securitizations exceeded the annual 

total volume of corporate bonds issued in the United States, 1 and (2) the collapse 

of the major investment banks. In overview, it is clear that the collapse of the investment banks was precipitated by laxity in the asset-backed securitization market 

(for which the SEC arguably may bear some responsibility), but that this laxity 

began with the reckless behavior of many investment banks. Collectively, they raced 

like lemmings over the cliff by abandoning the usual principles of sound risk management both by (i) increasing their leverage dramatically after 2004, and (ii) abandoning diversification in pursuit of obsessive focus on high-profit securitizations. Although these firms were driven by intense competition and short-term oriented systems of executive compensation, their ability to race over the cliff depended on their 

ability to obtain regulatory exemptions from the SEC. Thus, as will be discussed, 

the SEC raced to deregulate. In 2005, it adopted Regulation AB (an acronym for 

‘‘Asset-Backed’’), which simplified the registration of asset-backed securitizations 

without requiring significant due diligence or responsible verification of the essential facts. Even more importantly, in 2004, it introduced its Consolidated Supervised 

Entity Program (‘‘CSE’’), which allowed the major investment banks to determine 

their own capital adequacy and permissible leverage by designing their own credit 

risk models (to which the SEC deferred). Effectively, the SEC abandoned its longstanding ‘‘net capital rule’’ 2 and deferred to a system of self-regulation for these 

firms, which largely permitted them to develop their own standards for capital adequacy. 

For the future, it is less important to allocate culpability and blame than to determine what responsibilities the SEC can perform adequately. The recent evidence 

suggests that the SEC cannot easily or effectively handle the role of systemic risk 

regulator or even the more modest role of a prudential financial supervisor, and it 
52 

3 I have made this argument in greater detail in an article with Professor Hillary Sale, which 

will appear in the 75th Anniversary of the SEC volume of the Virginia Law Review. See Coffee 

and Sale, ‘‘Redesigning the SEC: Does the Treasury Have a Better Idea?’’ (available on the Social Science Research Network at http://ssrn.com/abstract=1309776). 4 Interestingly, this same diagnosis was recently given by SEC Chairman Christopher Cox to 

this Committee. See Testimony of SEC Chairman Christopher Cox before the Committee on 

Banking, Housing and Urban Affairs, United States Senate, September 23, 2008. Perhaps defensively, Chairman Cox located the origins of the crisis in the failure of Congress to give the SEC 

jurisdiction over investment bank holding companies or over-the-counter derivatives (including 

credit default swaps), thereby creating a regulatory void. 5For example, the high-tech Internet bubble that burst in early 2000 was a demand-driven 

bubble. Investors simply overestimated the value of the Internet, and for a time initial public 

offerings of ‘‘dot.com’’ companies would trade at ridiculous and unsustainable multiples. But full 

disclosure was provided to investors and the SEC cannot be faulted in this bubble—unless one 

assigns it the very paternalistic responsibility of protecting investors from themselves. 6This is best evidenced by the work of two University of Chicago Business School professors 

discussed below. See Atif Mian and Amir Sufi, ‘‘The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis’’, (http://ssrn.com/abstract=1072304) 

(May 2008). 

may be more subject to capture on these issues than other agencies. This leads me 

to conclude (along with others) that the U.S. needs one systemic risk regulator who, 

among other tasks, would have responsibility for the capital adequacy and safety 

and soundness of all institutions that are too ‘‘big to fail.’’ 3 The key advantage of 

a unified systemic risk regulator with jurisdiction over all large financial institutions is that it solves the critical problem of regulatory arbitrage. AIG, which has 

already cost U.S. taxpayers over $150 billion, presents the paradigm of this problem 

because it managed to issue billions in credit default swaps without becoming subject to regulation by any regulator at either the federal or state level. 

But one cannot stop with this simple prescription. The next question becomes 

what should be the relationship between such a systemic risk regulator and the 

SEC? Should the SEC simply be merged into it or subordinated to it? I will argue 

that it should not. Rather, the U.S. should instead follow a ‘‘twin peaks’’ structure 

(as the Treasury Department actually proposed in early 2008 before the current crisis crested) that assigns prudential supervision to one agency and consumer protection and transparency regulation to another. Around the globe, countries are today 

electing between a unified financial regulator (as typified by the Financial Services 

Authority (‘‘FSA’’) in the U.K.) and a ‘‘twin peaks’’ model (which both Australia and 

The Netherlands have followed). I will argue that the latter model is preferable because it deals better with serious conflict of interest problems and the differing cultures of securities and banking regulators. By culture, training, and professional orientation, banking regulators are focused on protecting bank solvency, and they historically have often regarded increased transparency as inimical to their interests, 

because full disclosure of a bank’s problems might induce investors to withdraw deposits and credit. The result can sometimes be a conspiracy of silence between the 

regulator and the regulated to hide problems. In contrast, this is one area where 

the SEC’s record is unblemished; it has always defended the principle that ‘‘sunlight 

is the best disinfectant.’’ Over the long-run, that is the sounder rule. 

If I am correct that a ‘‘twin peaks’’ model is superior, then Congress has to make 

clear the responsibilities of both agencies in any reform legislation in order to avoid 

predictable jurisdictional conflicts and to identify a procedure by which to mediate 

those disputes that are unavoidable. 

What Went Wrong? 

This section will begin with the problems in the mortgage loan market, then turn 

to the failure of credit-rating agencies, and finally examine the SEC’s responsibility 

for the collapse of the major investment banks. 

The Great American Real Estate Bubble 

The earliest origins of the 2008 financial meltdown probably lie in deregulatory 

measures, taken by the U.S. Congress at the end of the 1990s, that placed some 

categories of derivatives and the parent companies of investment banks beyond effective regulation. 4 Still, most accounts of the crisis start by describing the rapid 

inflation of a bubble in the U.S. housing market. Here, one must be careful. The 

term ‘‘bubble’’ can be a substitute for closer analysis and may carry a misleading 

connotation of inevitability. In truth, bubbles fall into two basic categories: those 

that are demand-driven and those that are supply-driven. The majority of bubbles 

fall into the former category, 5 but the 2008 financial market meltdown was clearly 

a supply-driven bubble, 6 fueled by the fact that mortgage loan originators came to 

realize that underwriters were willing to buy portfolios of mortgage loans for asset- 
53 

7 Interestingly, ‘‘moral hazard’’ problems also appear to have underlain the ‘‘savings and loan’’ 

crisis in the United States in the 1980s, which was the last great crisis involving financial institutions in the United States. For a survey of recent banking crises making this point, see Note, 

Anticipatory Regulation for the Management of Banking Crises, 38 Colum. J. L. & Soc. Probs. 

251 (2005). 8See Mian and Sufi, supra note 6, at 11 to 13. 9 Id. at 18-19. 10 Id. at 19. 11 Id. at 20-21. 12 Id. 13See Benjamin J. Keys, Tanmoy K. Mukherjee, Amit Seru, and Vikrant Vig, ‘‘Did 

Securitization Lead to Lax Screening? Evidence from Subprime Loans,’’ (http://ssrn.com/ 

abstract=1093137) (April, 2008). These authors conclude that securitization did result in ‘‘lax 

screening.’’ 14The President’s Working Group on Financial Markets, ‘‘Policy Statement on Financial Market Developments,’’ at 1 (March 2008). 

backed securitizations without any serious investigation of the underlying collateral. 

With that recognition, loan originators’ incentive to screen borrowers for creditworthiness dissipated, and a full blown ‘‘moral hazard’’ crisis was underway. 7

The evidence is clear that, between 2001 and 2006, an extraordinary increase occurred in the supply of mortgage funds, with much of this increased supply being 

channeled into poorer communities in which previously there had been a high denial 

rate on mortgage loan applications. 8 With an increased supply of mortgage credit, 

housing prices rose rapidly, as new buyers entered the market. But at the same 

time, a corresponding increase in mortgage debt relative to income levels in these 

same communities made these loans precarious. A study by University of Chicago 

Business School professors has found that two years after this period of increased 

mortgage availability began, a corresponding increase started in mortgage defaults—in exactly the same zip code areas where there had been a high previous 

rate of mortgage loan denials. 9 This study determined that a one standard deviation 

in the supply of mortgages from 2001 to 2004 produced a one standard deviation 

increase thereafter in mortgage default rates. 10

Even more striking, however, was its finding that the rate of mortgage defaults 

was highest in those neighborhoods that had the highest rates of securitization. 11

Not only did securitization correlate with a higher rate of default, but that rate of 

default was highest when the mortgages were sold by the loan originator to financial firms unaffiliated with the loan originator. 12 Other researchers have reached 

a similar conclusion: conditional on its being actually securitized, a loan portfolio 

that was more likely to be securitized was found to default at a 20 percent higher 

rate than a similar risk profile loan portfolio that was less likely to be securitized. 13

Why? The most plausible interpretation is that securitization adversely affected the 

incentives of lenders to screen their borrowers. 

Such a conclusion should not surprise. It simply reflects the classic ‘‘moral hazard’’ problem that arises once loan originators did not bear the cost of default by 

their borrowers. As early as March, 2008, The President’s Working Group on Financial Markets issued a ‘‘Policy Statement on Financial Market Developments’’ that 

explained the financial crisis as the product of five ‘‘principal underlying causes of 

the turmoil in financial markets’’: 

• a breakdown in underwriting standards for subprime mortgages; 

• a significant erosion of market discipline by those involved in the securitization 

process, including originators, underwriters, credit rating agencies, and global 

investors, related in part to failures to provide or obtain adequate risk disclosures; 

• flaws in credit rating agencies’ assessment of subprime residential mortgages 

. . . and other complex structured credit products, . . . 

• risk management weaknesses at some large U.S. and European financial institutions; and 

• regulatory policies, including capital and disclosure requirements, that failed to 

mitigate risk management weaknesses. 14

Correct as the President’s Working Group was in noting the connection between 

the decline of discipline in the mortgage loan origination market and a similar laxity among underwriters in the capital markets, it did not focus on the direction of 

the causality. Did mortgage loan originators fool or defraud investment bankers? Or 

did investment bankers signal to loan originators that they would buy whatever the 

loan originators had to sell? The available evidence tends to support the latter hypothesis: namely, that irresponsible lending in the mortgage market was a direct 
54 

15See Allen Ferrell, Jennifer Bethel and Gang Hu, Legal and Economic Issues in Litigation 

Arising from the 2007-2008 Credit Crisis (Harvard Law & Economics Discussion Paper No. 612, 

Harvard Law School Program in Risk Regulation Research Paper No. 08-5) at Table 4. 16See text and notes infra at notes 56 to 61. 17 Investment banks formerly had relied on ‘‘due diligence’’ firms that they employed to determine whether the loans within a loan portfolio were within standard parameters. These firms 

would investigate and inform the underwriter as to the percentage of the loans that were ‘‘exception’’ loans (i.e., loans outside the investment bank’s normal guidelines). Subsequent to 2000, 

the percentage of ‘‘exception loans’’ in portfolios securitized by these banks often rose from the 

former level of 25 percent to as high as 80 percent. Also, the underwriters scaled back the intensity of the investigations that they would authorize the ‘‘due diligence’’ firm to conduct, reducing 

from 30 percent to as few as 5 percent the number of loans in a portfolio that it was to check. 

See Vikas Bajaj & Jenny Anderson, ‘‘Inquiry Focuses on Withholding of Data on Loans,’’ N.Y. 

Times, January 12, 2008, at p. A-1. 18See Richard Mendales, ‘‘Collateralized Explosive Devices: Why Securities Regulation Failed 

to Prevent the CDO Meltdown And How To Fix It’’ (Working Paper 2008) at 36 (forthcoming 

in 2009, U. Ill. L. Rev.). 19See Securities Act Release No. 8518 (‘‘Asset-Backed Securities’’) (January 7, 2005, 79 FR 

1506). Regulation AB codified a series of ‘‘no action’’ letters and established disclosures standards for all asset-backed securitizations. See 17 C.F.R. §§ 229.1100-1123 (2005). Although it did 

not represent a sharp deregulatory break with the past, Regulation AB did reduce the due diligence obligation of underwriters by eliminating any need to assure that assets included in a 

securitized pool were adequately documented. See Mendales, supra note 18. 

response to the capital markets’ increasingly insatiable demand for financial assets 

to securitize. If underwriters were willing to rush deeply flawed asset-backed 

securitizations to the market, mortgage loan originators had no rational reason to 

resist them. 

The rapid deterioration in underwriting standards for subprime mortgage loans 

is revealed at a glance in the following table: 15

Underwriting Standards in Subprime Home-Purchase Loans, 2001–2006 

Year Low/No-Doc 

Share 

Debt 

Payments/ 

Income 

Loan/Value ARM Share InterestOnly Share 

2001 ................................................................ 28.5% 39.7% 84.0% 73.8% 0.0% 

2002 ................................................................ 38.6% 40.1% 84.4% 80.0% 2.3% 

2003 ................................................................ 42.8% 40.5% 86.1% 80.1% 8.6% 

2004 ................................................................ 45.2% 41.2% 84.9% 89.4% 27.3% 

2005 ................................................................ 50.7% 41.8% 83.2% 93.3% 37.8% 

2006 ................................................................ 50.8% 42.4% 83.4% 91.3% 22.8% 

Source: Freddie Mac, obtained from the International Monetary Fund. 

The investment banks could not have missed that low document loans (also called 

‘‘liar loans’’) rose from 28.5 percent to 50.8 percent over the 5 year interval between 

2001 and 2006 or that ‘‘interest only’’ loans (on which there was no amortization 

of principal) similarly grew from 6 percent to 22.8 percent over this same interval. 

Thus, the real mystery is not why loan originators made unsound loans, but why 

underwriters bought them. Here, it seems clear that both investment and commercial banks saw high profits in securitizations and believed they could quickly sell 

on a global basis any securitized portfolio of loans that carried an investment grade 

rating. In addition, investment banks may have had a special reason to focus on 

securitizations: structured finance offered a level playing field where they could 

compete with commercial banks, whereas, as discussed later, commercial banks had 

inherent advantages at underwriting corporate debt and were gradually squeezing 

the independent investment banks out of this field. 16 Consistent with this interpretation, anecdotal evidence suggests that due diligence efforts within the underwriting community slackened in asset-backed securitizations after 2000. 17 Others 

have suggested that the SEC contributed to this decline by softening its disclosure 

and due diligence standards for asset-backed securitizations, 18 in particular by 

adopting in 2005 Regulation AB, which covers the issuance of asset backed securities. 19 From this perspective, relaxed discipline in both the private and public sectors overlapped to produce a disaster. 

Credit Rating Agencies as Gatekeepers 

It has escaped almost no one’s attention that the credit rating agencies bear much 

responsibility for the 2008 financial crisis, with the consensus view being that they 

inflated their ratings in the case of structured finance offerings. Many reasons have 

been given for their poor performance: (1) rating agencies faced no competition (be-
55 

20For these and other explanations, see Coffee, GATEKEEPERS: The Professions and Corporate Governance (Oxford University Press, 2006), and Frank Partnoy, ‘‘How and Why Credit 

Rating Agencies Are Not Like Other Gatekeepers’’ (http://ssrn.com/abstract=900257) (May 

2006). 21See Partnoy, supra note 20. 22See In re Moody’s Corporation Securities Litigation, 2009 U.S. Dist. LEXIS 13894 (S.D.N.Y. 

February 23, 2009) at *6 (also noting that Moody’s grossed $1.635 billion from its ratings business in 2006). 23See Gretchen Morgenson, ‘‘Debt Watchdogs: Tamed or Caught Napping?’’ New York Times, 

December 7, 2008, at p. 1, 40. 24 Id. 

cause there are really only three major rating agencies); (2) they were not disciplined by the threat of liability (because credit rating agencies in the U.S. appear 

never to have been held liable and almost never to have settled a case with any 

financial payment); (3) they were granted a ‘‘regulatory license’’ by the SEC, which 

has made an investment grade rating from a rating agency that was recognized by 

the SEC a virtual precondition to the purchase of debt securities by many institutional investors; (4) they are not required to verify information (as auditors and securities analysts are), but rather simply express views as to the creditworthiness of 

the debt securities based on the assumed facts provided to them by the issuer. 20

These factors all imply that credit rating agencies had less incentive than other 

gatekeepers to protect their reputational capital from injury. After all, if they face 

little risk that new entrants could enter their market to compete with them or that 

they could be successfully sued, they had less need to invest in developing their 

reputational capital or taking other precautions. All that was necessary was that 

they avoid the type of major scandal, such as that which destroyed Arthur Andersen 

& Co., the accounting firm, that had made it impossible for a reputable company 

to associate with them. 

Much commentary has suggested that the credit rating agencies were compromised by their own business model, which was an ‘‘issuer pays’’ model under 

which nearly 90 percent of their revenues came from the companies they rated. 21

Obviously, an ‘‘issuer pays’’ model creates a conflict of interest and considerable 

pressure to satisfy the issuer who paid them. Still, neither such a conflicted business model nor the other factors listed above can explain the dramatic deterioration 

in the performance of the rating agencies over the last decade. Both Moody’s and 

Standard & Poor were in business before World War I and performed at least acceptably until the later 1990s. To account for their more recent decline in performance, one must point to more recent developments and not factors that long were 

present. Two such factors, each recent and complementary with the other, do provide a persuasive explanation for this deterioration: (1) the rise of structured finance 

and the change in relationships that it produced between the rating agencies and 

their clients; and (2) the appearance of serious competition within the ratings industry that challenged the long stable duopoly of Moody’s and Standard & Poor’s and 

that appears to have resulted in ratings inflation. 

First, the last decade witnessed a meteoric growth in the volume and scale of 

structured finance offerings. One impact of this growth was that it turned the rating 

agencies from marginal, basically break-even enterprises into immensely profitable 

enterprises that rode the crest of the breaking wave of a new financial technology. 

Securitizations simply could not be sold without ‘‘investment grade’’ credit ratings 

from one or more of the Big Three rating agencies. Structured finance became the 

rating agencies’ leading source of revenue. Indeed by 2006, structured finance accounted for 54.2 percent of Moody’s revenues from its ratings business and 43.5 percent of its overall revenues. 22 In addition, rating structured finance products generated much higher fees than rating similar amounts of corporate bonds. 23 For example, rating a $350 million mortgage pool could justify a fee of $200,000 to 

$250,000, while rating a municipal bond of similar size justified only a fee of 

$50,000. 24

Beyond simply the higher profitability of rating securitized transactions, there 

was one additional difference about structured finance that particularly compromised the rating agencies as gatekeepers. In the case of corporate bonds, the rating agencies rated thousands of companies, no one of which controlled any significant volume of business. No corporate issuer, however large, accounted for any significant share of Moody’s or S&P’s revenues. But with the rise of structured finance, 

the market became more concentrated. As a result, the major investment banks acquired considerable power over the rating agencies, because each of them had 

‘‘clout,’’ bringing highly lucrative deals to the agencies on a virtually monthly basis. 

As the following chart shows, the top six underwriters controlled over 50 percent 

of the mortgage-backed securities underwriting market in 2007, and the top eleven 
56 

25See Ferrell, Bethel, and Hu, supra note 15, at Table 2. For anecdotal evidence that ratings 

were changed at the demand of the investment banks, see Morgenson, supra note 23. 26 Bo Becker and Todd Milburn, ‘‘Reputation and Competition: Evidence from the Credit Rating Industry,’’ Harvard Business School, Working Paper No. 09-051 (2008) (http://ssrn.com/abstract =1278150) at p. 4. 27 Id. at 17. 

underwriters each had more than 5 percent of the market and in total controlled 

roughly 80 percent of this very lucrative market on whom the rating agencies relied 

for a majority of their ratings revenue: 25

MBS Underwriters in 2007 

Rank Book Runner 

Number of Offerings 

Market 

Share 

Proceed Amount + 

Overallotment Sold in U.S. ($mill) 

1 ......................... Lehman Brothers 120 10.80% $100,109 

2 ......................... Bear Stearns & Co., Inc. 128 9.90% 91,696 

3 ......................... Morgan Stanley 92 8.20% 75,627 

4 ......................... JPMorgan 95 7.90% 73,214 

5 ......................... Credit Suisse 109 7.50% 69,503 

6 ......................... Bank of America Securities LLC 101 6.80% 62,776 

7 ......................... Deutsche Bank AG 85 6.20% 57,337 

8 ......................... Royal Bank of Scotland Group 74 5.80% 53,352 

9 ......................... Merrill Lynch 81 5.20% 48,407 

10 ....................... Goldman Sachs & Co. 60 5.10% 47,696 

11 ....................... Citigroup 95 5.00% 46,754 

12 ....................... UBS 74 4.30% 39,832 

If the rise of structured finance was the first factor that compromised the credit 

rating agencies, the second factor was at least as important and had an even clearer 

empirical impact. Until the late 1990s, Moody’s and Standard & Poor’s shared a duopoly over the rating of U.S. corporate debt. But, over the last decade, a third agency, Fitch Ratings, grew as the result of a series of mergers and increased its U.S. 

market share from 10 percent to approximately a third of the market. 26 The rise 

of Fitch challenged the established duopoly. What was the result? A Harvard Business School study has found three significant impacts: (1) the ratings issued by the 

two dominant rating agencies shifted significantly in the direction of higher ratings; 

(2) the correlation between bond yields and ratings fell, suggesting that under competitive pressure ratings less reflected the market’s own judgment; and (3) the negative stock market reaction to bond rating downgrades increased, suggesting that a 

downgrade now conveyed worse news because the rated offering was falling to an 

even lower quality threshold than before. 27 Their conclusions are vividly illustrated 

by one graph they provide that shows the correlation between grade inflation and 

higher competition: 
57 

28 Id. at 21. 29See ‘‘Ratings Game—As Housing Boomed, Moody’s Opened Up,’’ The Wall Street Journal, 

April 11, 2008, at p. A-1. 30For a concise overview of these developments, see Jon Hilsenrath, Damian Palette, and 

Aaron Lucchetti, ‘‘Goldman, Morgan Scrap Wall Street Model, Become Banks in Bid To Ride 

Out Crisis,’’ The Wall Street Journal, September 22, 2008, at p. A-1 (concluding that independent investment banks could not survive under current market conditions and needed closer 

regulatory supervision to establish credibility). 31See Securities Exchange Act Release No. 34-49830 (June 21, 2004), 69 FR 34428 (‘‘Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised 

Entities’’). 

Under high competition, lower ratings declined and investment grade rations 

soared. The authors conclude that increased competition may impair ‘‘the 

reputational mechanism that underlies the provision of good quality ratings.’’ 28

The anecdotal evidence supports a similar conclusion: the major rating agencies 

responded to the competitive threat from Fitch by making their firms ‘‘more clientfriendly and focused on market share.’’ 29 Put simply, the evidence implies that the 

rapid change toward a more competitive environment made the competitors not 

more faithful to investors, but more dependent on their immediate clients, the 

issuers. From the standpoint of investors, agency costs increased. 

The Responsibility of the SEC 

Each of the major investment banks that failed, merged, or converted into bank 

holding companies in 2008 had survived prior recessions, market panics, and repeated turmoil and had long histories extending back as far as the pre-Civil War 

era. Yet, each either failed or was gravely imperiled within the same basically 6 

month period following the collapse of Bear Stearns in March 2008. 30

If their uniform collapse is not alone enough to suggest the likelihood of regulatory failure, one additional common fact unites them: each of these five firms voluntarily entered into the SEC’s Consolidated Supervised Entity (‘‘CSE’’) Program, 

which was established by the SEC in 2004 for only the largest investment banks. 31

Indeed, these five investment banks were the only investment banks permitted by 

the SEC to enter the CSE program. A key attraction of the CSE Program was that 

it permitted its members to escape the SEC’s traditional net capital rule, which 

placed a maximum ceiling on their debt to equity ratios, and instead elect into a 
58 

32The SEC’s ‘‘net capital rule,’’ which dates back to 1975, governs the capital adequacy and 

aggregate indebtedness permitted for most broker-dealers. See Rule 15c3-1 (‘‘Net Capital Requirements for Brokers and Dealers’’). 17 C.F.R. § 240.15c3-1. Under subparagraph (a)(1)(i) of 

this rule, aggregate indebtedness is limited to fifteen times the broker-dealer’s net capital; a 

broker-dealer may elect to be governed instead by subparagraph (a)(1)(ii) of this rule, which requires it maintain its net capital at not less than the greater of $250,000 or two percent of ‘‘aggregate debit items’’ as computed under a special formula that gives ‘‘haircuts’’ (i.e., reduces the 

valuation) to illiquid securities. Both variants place fixed limits on leverage. 33This chart comes from U.S. Securities and Exchange Commission, Office of the Inspector 

General, ‘‘SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Entity Program’’ (‘Report No. 446-A, September 25, 2008) (hereinafter ‘‘SEC Inspector General Report’’) at 

Appendix IX at p. 120. 34See SEC Inspector General Report at 19. 35See Ferrell, Bethel, and Hu, supra note 15, at Table 8. Value at risk estimates have proven 

to be inaccurate predictors of the actual writedowns experienced by banks. They are cited here 

not because they are accurate estimates of risk, but because the percentage increases at the investment banks was generally extreme. Even Goldman Sachs, which survived the crisis in better 

shape than its rivals, saw its VaR estimate more than double over this period. 

more relaxed ‘‘alternative net capital rule’’ that contained no similar limitation. 32

The result was predictable: all five of these major investment banks increased their 

debt-to-equity leverage ratios significantly over the brief two year period following 

their entry into the CSE Program, as shown by Figure 1 below: 33

For example, at the time of its insolvency, Bear Stearns’ gross leverage ratio had 

hit 33 to 1. 34

The above chart likely understates the true increase in leverage because gross leverage (i.e., assets divided by equity) does not show the increase in off-balance sheet 

liabilities, as the result of conduits and liquidity puts. Thus, another measure may 

better show the sudden increase in risk. One commonly used metric for banks is 

the bank’s value at risk (VaR) estimate, which banks report to the SEC in their annual report on Form 10-K. This measure is intended to show the risk inherent in 

their financial portfolios. The chart below shows ‘‘Value at Risk’’ for the major underwriters over the interval 2004 to 2007: 35
59 

36For the bluntest statement of this thesis, see Stephen Labaton, ‘‘S.E.C. Concedes Oversight 

Plans Fueled Collapse,’’ New York Times, September 27, 2008, at p. 1. Nonetheless, this analysis 

is oversimple. Although SEC Chairman Cox did indeed acknowledge that there were flaws in 

the ‘‘Consolidated Supervised Entity’’ Program, he did not concede that it ‘‘fueled’’ the collapse 

or that it represented deregulation. As discussed below, the SEC probably legitimately believed 

that it was gaining regulatory authority from the CSE Program (but it was wrong). 37See Council Directive 2002/87, Financial Conglomerates Directive, 2002 O.J. (L 35) of the 

European Parliament and of the Council of 16 December 2002 on the supplementary supervision 

of credit institutions, insurance undertakings and investment firms in a financial conglomerate 

and amending Council Directives. For an overview of this directive and its rationale, see Jorge 

E. Vinuales, The International Regulation of Financial Conglomerates: A Case Study of Equivalence as an Approach to Financial Integration, 37 Cal. W. Int’l L.J. 1, at 2 (2006). 38Different European regulators appear to have been feared by different entities. Some commercial banks saw French regulation as potentially hostile, while U.S. broker-dealers, all largely 

Continued 

Value at Risk, 2004–2007 

Firms 2004 

($mil) 

2005 

($mil) 

2006 

($mil) 

2007 

($mil) 

Bank of America ...................................................................................................... $44.1 $41.8 $41.3 - 

Bear Stearns ............................................................................................................ 14.8 21.4 28.8 $69.3 

Citigroup .................................................................................................................. 116.0 93.0 106.0 - 

Credit Suisse ........................................................................................................... 55.1 66.2 73.0 - 

Deutsche Bank ......................................................................................................... 89.8 82.7 101.5 - 

Goldman Sachs ........................................................................................................ 67.0 83.0 119.0 134.0 

JPMorgan .................................................................................................................. 78.0 108.0 104.0 - 

Lehman Brothers ..................................................................................................... 29.6 38.4 54.0 124.0 

Merrill Lynch ............................................................................................................ 34.0 38.0 52.0 - 

Morgan Stanley ........................................................................................................ 94.0 61.0 89.0 83.0 

UBS .......................................................................................................................... 103.4 124.7 132.8 - 

Wachovia .................................................................................................................. 21.0 18.0 30.0 - 

VaR statistics are reported in the 10K or 20F (in the case of foreign firms) of the respective firms. Note that the firms use different assumptions in computing their Value of Risk. Some annual reports are not yet avaialble for 2007. 

Between 2004 and 2007, both Bear Stearns and Lehman more than quadrupled 

their value at risk estimates, while Merrill Lynch’s figure also increased significantly. Not altogether surprisingly, they were the banks that failed. 

These facts provide some corroboration for an obvious hypothesis: excessive deregulation by the SEC caused the liquidity crisis that swept the global markets in 

2008. 36 Still, the problem with this simple hypothesis is that it may be too simple. 

Deregulation did contribute to the 2008 financial crisis, but the SEC’s adoption of 

the CSE Program in 2004 was not intended to be deregulatory. Rather, the program 

was intended to compensate for earlier deregulatory efforts by Congress that had 

left the SEC unable to monitor the overall financial position and risk management 

practices of the nation’s largest investment banks. Still, even if the 2004 net capital 

rule changes were not intended to be deregulatory, they worked out that way in 

practice. The ironic bottom line is that the SEC unintentionally deregulated by introducing an alternative net capital rule that it could not effectively monitor. 

The events leading up to the SEC’s decision to relax its net capital rule for the 

largest investment banks began in 2002, when the European Union adopted its Financial Conglomerates Directive. 37 The main thrust of the E.U.’s new directive was 

to require regulatory supervision at the parent company level of financial conglomerates that included a regulated financial institution (e.g., a broker-dealer, bank or 

insurance company). The E.U.’s entirely reasonable fear was that the parent company might take actions that could jeopardize the solvency of the regulated subsidiary. The E.U.’s directive potentially applied to the major U.S. investment and 

commercial banks because all did substantial business in London (and elsewhere in 

Europe). But the E.U.’s directive contained an exemption for foreign financial conglomerates that were regulated by their home countries in a way that was deemed 

‘‘equivalent’’ to that envisioned by the directive. For the major U.S. commercial 

banks (several of which operated a major broker-dealer as a subsidiary), this afforded them an easy means of avoiding group-wide supervision by regulators in Europe, because they were subject to group-level supervision by U.S. banking regulators. 

U.S. investment banks had no similar escape hatch, as the SEC had no similar 

oversight over their parent companies. Thus, fearful of hostile regulation by some 

European regulators, 38 U.S. investment banks lobbied the SEC for a system of 
60 

based in London, did not want their holding companies to be overseen by the U.K.’s Financial 

Services Agency (FSA). 39See Stephen Labaton, ‘‘Agency’s ’04 Rule Let Banks Pile Up Debt and Risk,’’ New York 

Times, October 3, 2008, at A-1 (describing major investment banks as having made an ‘‘urgent 

plea’’ to the SEC in April, 2004). 40See Securities Exchange Act Release No. 34-49830, supra note 31. 41See Rule 15c3-1(a)(1)(i)(‘‘Alternative Indebtedness Standard’’), 17 C.F.R. § 240.15c3-1(a)(1). 42See Rule 15c3-1(a)(1)(ii)(‘‘Alternative Standard’’), 17 C.F.R. § 240.15c3-1(a)(1)(ii). This alternative standard is framed in terms of the greater of $250,000 or 2 percent, but for any investment bank of any size, 2 percent will be the greater. Although this alternative standard may 

sound less restrictive, it was implemented by a system of ‘‘haircuts’’ that wrote down the value 

of investment assets to reflect their illiquidity. 43See SEC Inspector General Report at 10-11. Under these standards, a ‘‘well-capitalized’’ 

bank was expected to maintain a 10 percent capital ratio. Id. at 11. Nonetheless, others have 

argued that Basel II ‘‘was not designed to be used by investment banks’’ and that the SEC 

‘‘ought to have been more careful in moving banks on to the new rules.’’ See ‘‘Mewling and Puking: Bank Regulation,’’ The Economist, October 25, 2008 (U.S. Edition). 44For the view that Basel II excessively deferred to commercial banks to design their own 

credit risk models and their increase leverage, see Daniel K. Tarullo, BANKING ON BASEL: 

The Future of International Financial Regulation (2008). Mr. Tarullo has recently been nominated by President Obama to the Board of Governors of the Federal Reserve Board. For the 

alternative view, that Basel II was uniquely unsuited for investment banks, see ‘‘Mewling and 

Puking,’’ supra note 43. 45SEC Inspector General Report, 10. 46The most prominent proponent of this view is Professor Daniel Tarullo. See supra note 44. 

‘‘equivalent’’ regulation that would be sufficient to satisfy the terms of the directive 

and give them immunity from European oversight. 39 For the SEC, this offered a 

serendipitous opportunity to oversee the operations of investment bank holding companies, which authority the SEC had sought for some time. Following the repeal of 

the Glass-Steagall Act, the SEC had asked Congress to empower it to monitor investment bank holding companies, but it had been rebuffed. Thus, the voluntary 

entry of the holding companies into the Consolidated Supervised Entity program 

must have struck the SEC as a welcome development, and Commission unanimously approved the program without any partisan disagreement. 40

But the CSE Program came with an added (and probably unnecessary) corollary: 

Firms that entered the CSE Program were permitted to adopt an alternative and 

more relaxed net capital rule governing their debt to net capital ratio. Under the 

traditional net capital rule, a broker-dealer was subject to fixed ceilings on its permissible leverage. Specifically, it either had to (a) maintain aggregate indebtedness 

at a level that could not exceed fifteen times net capital, 41 or (b) maintain minimum 

net capital equal to not less than two percent of ‘‘aggregate debit items.’’ 42 For most 

broker-dealers, this 15 to 1 debt to net capital ratio was the operative limit within 

which they needed to remain by a comfortable margin. 

Why did the SEC allow the major investment banks to elect into an alternative 

regime that placed no outer limit on leverage? Most likely, the Commission was 

principally motivated by the belief that it was only emulating the more modern 

‘‘Basel II’’ standards that the Federal Reserve Bank and European regulators were 

then negotiating. To be sure, the investment banks undoubtedly knew that adoption 

of Basel II standards would permit them to increase leverage (and they lobbied hard 

for such a change). But, from the SEC’s perspective, the goal was to design the CSE 

Program to be broadly consistent with the Federal Reserve’s oversight of bank holding companies, and the program even incorporated the same capital ratio that the 

Federal Reserve mandated for bank holding companies. 43 Still, the Federal Reserve 

introduced its Basel II criteria more slowly and gradually, beginning more than a 

year later, while the SEC raced in 2004 to introduce a system under which each 

investment bank developed its own individualized credit risk model. Today, some believe that Basel II represents a flawed model even for commercial banks, while others believe that, whatever its overall merits, it was particularly ill-suited for investment banks. 44

Yet, what the evidence demonstrates most clearly is that the SEC simply could 

not implement this model in a fashion that placed any real restraint on its subject 

CSE firms. The SEC’s Inspector General examined the failure of Bear Stearns and 

the SEC’s responsibility therefor and reported that Bear Stearns had remained in 

compliance with the CSE Program’s rules at all relevant times. 45 Thus, if Bear 

Stearns had not cheated, this implied (as the Inspector General found) that the CSE 

Program, itself, had failed. The key question is then what caused the CSE Program 

to fail. Here, three largely complementary hypotheses are plausible. First, the Basel 

II Accords may be flawed, either because they rely too heavily on the banks’ own 

self-interested models of risk or on the highly conflicted ratings of the major credit 

rating agencies. 46 Second, even if Basel II made sense for commercial banks, it may 
61 

47See ‘‘Mewling and Puking,’’ supra note 43. 48The SEC adopted its CSE program in 2004. The Federal Reserve only agreed in principle 

to Basel II in late 2005. See Stavros Gadinis, The Politics of Competition in International Financial Regulation, 49 Harv. Int’l L. J. 447, 507 n. 192 (2008). 49SEC Inspector General Report at 2. 50 Id. Similarly, the Office of CSE Inspectors had only seven staff. Id. 51Moreover, the process effectively ceased to function well before the 2008 crisis hit. After 

SEC Chairman Cox re-organized the CSE review process in the Spring of 2007, the staff did 

not thereafter complete ‘‘a single inspection.’’ See Labaton, supra note 39. 52SEC Inspector General Report at ix. 53SEC Inspector General Report at ix. 

have been ill-suited for investment banks. 47 Third, whatever the merits of Basel II 

in theory, the SEC may have simply been incapable of implementing it. 

Clearly, however, the SEC moved faster and farther to defer to self-regulation by 

means of Basel II than did the Federal Reserve. 48 Clearly also, the SEC’s staff was 

unable to monitor the participating investment banks closely or to demand specific 

actions by them. Basel II’s approach to the regulation of capital adequacy at financial institutions contemplated close monitoring and supervision. Thus, the Federal 

Reserve assigns members of its staff to maintain an office within a regulated bank 

holding company in order to provide constant oversight. In the case of the SEC, a 

team of only three SEC staffers were assigned to each CSE firm 49 (and a total of 

only thirteen individuals comprised the SEC’s Office of Prudential Supervision and 

Risk Analysis that oversaw and conducted this monitoring effort). 50 From the start, 

it was a mismatch: three SEC staffers to oversee an investment bank the size of 

Merrill Lynch, which could easily afford to hire scores of highly quantitative economists and financial analysts, implied that the SEC was simply outgunned. 51

This mismatch was compounded by the inherently individualized criteria upon 

which Basel II relies. Instead of applying a uniform standard (such as a specific 

debt to equity ratio) to all financial institutions, Basel II contemplated that each 

regulated financial institution would develop a computer model that would generate 

risk estimates for the specific assets held by that institution and that these estimates would determine the level of capital necessary to protect that institution from 

insolvency. Thus, using the Basel II methodology, the investment bank generates a 

mathematical model that crunches historical data to evaluate how risky its portfolio 

assets were and how much capital it needed to maintain to protect them. Necessarily, each model was ad hoc, specifically fitted to that specific financial institution. But no team of three SEC staffers was in a position to contest these individualized models or the historical data used by them. Effectively, the impact of the Basel 

II methodology was to shift the balance of power in favor of the management of the 

investment bank and to diminish the negotiating position of the SEC’s staff. Whether or not Basel II’s criteria were inherently flawed, it was a sophisticated tool that 

was beyond the capacity of the SEC’s largely legal staff to administer effectively. 

The SEC’s Inspector General’s Report bears out this critique by describing a variety of instances surrounding the collapse of Bear Stearns in which the SEC’s staff 

did not respond to red flags that the Inspector General, exercising 20/20 hindsight, 

considered to be obvious. The Report finds that although the SEC’s staff was aware 

that Bear Stearns had a heavy and increasing concentration in mortgage securities, 

it ‘‘did not make any efforts to limit Bear Stearns mortgage securities concentration.’’ 52 In its recommendations, the Report proposed both that the staff become 

‘‘more skeptical of CSE firms’ risk models’’ and that it ‘‘develop additional stress scenarios that have not already been contemplated as part of the prudential regulation 

process.’’ 53

Unfortunately, the SEC Inspector General Report does not seem realistic on this 

score. The SEC’s staff cannot really hope to regulate through gentle persuasion. Unlike a prophylactic rule (such as the SEC’s traditional net capital rule that placed 

a uniform ceiling on leverage for all broker-dealers), the identification of ‘‘additional 

stress scenarios’’ by the SEC’s staff does not necessarily lead to specific actions by 

the CSE firms; rather, such attempts at persuasion are more likely to produce an 

extended dialogue, with the SEC’s staff being confronted with counter-models and 

interpretations by the financial institution’s managers. 

The unfortunate truth is that in an area where financial institutions have intense 

interests (such as over the question of their maximum permissible leverage), a government agency in the U.S. is unlikely to be able to obtain voluntary compliance. 

This conclusion is confirmed by a similar assessment from the individual with perhaps the most recent experience in this area. Testifying in September, 2008 testimony before the Senate Banking Committee, SEC Chairman Christopher Cox emphasized the infeasibility of voluntary compliance , expressing his frustration with 

attempts to negotiate issues such as leverage and risk management practices with 
62 

54See Testimony of SEC Chairman Christopher Cox before the Committee on Banking, Housing, and Urban Affairs, United States Senate, September 23, 2008 (‘‘Testimony Concerning Turmoil in U.S. Credit Markets: Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions’’), at p. 4 (available at www.sec.gov) (emphasis 

added). Chairman Cox has repeated this theme in a subsequent Op/Ed column in the Washington Post, in which he argued that ‘‘Reform legislation should steer clear of voluntary regulation and grant explicit authority where it is needed.’’ See Christopher Cox, ‘‘Reinventing A Market Watchdog,’’ the Washington Post, November 4, 2008, at A-17. 55 Chairman Cox added in the next sentence of his Senate testimony: ‘‘There is simply no provision in the law authorizes the CSE Program, or requires investment bank holding companies 

to compute capital measures or to maintain liquidity on a consolidated basis, or to submit to 

SEC requirements regarding leverage.’’ Id. This is true, but if a CSE firm left the CSE program, 

it would presumably become subject to European regulation; thus, the system was not entirely 

voluntary and the SEC might have used the threat to expel a non-compliant CSE firm. The 

SEC’s statements about the degree of control they had over participants in the CSE Program 

appear to have been inconsistent over time and possibly defensively self-serving. But clearly, 

the SEC did not achieve voluntary compliance. 56See Terry Pristin, ‘‘Risky Real Estate Deals Helped Doom Lehman,’’ N.Y. Times, September 

17, 2008, at C-6 (discussing Lehman’s expensive, multi-billion dollar acquisition of ArchstoneSmith); Gretchen Morgenson, ‘‘How the Thundering Herd Faltered and Fell,’’ N.Y. Times, November 9, 2008, at B4-1 (analyzing Merrill Lynch’s failure and emphasizing its acquisitions of 

loan originators). 57See Michiyo Nakamoto & David Wighton, ‘‘Citigroup Chief Stays Bullish on Buy-Outs,’’ Financial Times, July 9, 2007, available at http://www.ft.com/cms/s/0/80e2987a-2e50-11dc-821c0000779fd2ac.html 58 Although a commercial bank, Citigroup was no exception this race, impelled by the high 

fee income it involved. From 2003 to 2005, ‘‘Citigroup more than tripled its issuing of C.D.O.s 

to more than $30 billion from $6.28 billion.’’ See Eric Dash and Julie Creswell, ‘‘Citigroup Pays 

for a Rush to Risk’’ New York Times, November 22, 2008, at 1, 34. In 2005 alone, the New York 

Times estimates that Citigroup received over $500 million in fee income from these C.D.O. 

transactions. From being the sixth largest issuer of C.D.O.s in 2003, it rose to being the largest 

the CSE firms. In a remarkable statement for a long-time proponent of deregulation, 

he testified: 

Beyond highlighting the inadequacy of the . . . CSE program’s capital and 

liquidity requirements, the last six months—during which the SEC and the 

Federal Reserve worked collaboratively with each of the CSE firms . . . 

—have made abundantly clear that voluntary regulation doesn’t work. 54

His point was that the SEC had no inherent authority to order a CSE firm to 

reduce its debt to equity ratio or to keep it in the CSE Program. 55 If it objected, 

a potentially endless regulatory negotiation might only begin. 

Ultimately, even if one absolves the SEC of ‘‘selling out’’ to the industry in adopting the CSE Program in 2004, it is still clear at a minimum that the SEC lacked 

both the power and the expertise to restrict leverage by the major investment 

banks, at least once the regulatory process began with each bank generating its own 

risk model. Motivated by stock market pressure and the incentives of a short-term 

oriented executive compensation system, senior management at these institutions 

affectively converted the process into self-regulation. 

One last factor also drove the rush to increased leverage and may best explain 

the apparent willingness of investment banks to relax their due diligence standards: 

competitive pressure and the need to establish a strong market share in a new and 

expanding market drove the investment banks to expand recklessly. For the major 

players in the asset-backed securitization market, the long-term risk was that they 

might be cut off from their source of supply, if loan originators were acquired by 

or entered into long-term relationships with their competitors, particularly the commercial banks. Needing an assured source of supply, some investment banks (most 

notably Lehman and Merrill, Lynch) invested heavily in acquiring loan originators 

and related real estate companies, thus in effect vertically integrating. 56 In so 

doing, they assumed even greater risk by increasing their concentration in real estate and thus their undiversified exposure to a downturn in that market. This need 

to stay at least even with one’s competitors best explains the now famous line uttered by Charles Prince, the then CEO of Citigroup in July, 2007, just as the debt 

market was beginning to collapse. Asked by the Financial Times if he saw a liquidity crisis looming, he answered: 

When the music stops, in terms of liquidity, things will get complicated. 

But as long as the music is playing, you’ve got to get up and dance. We’re 

still dancing. 57

In short, competition among the major investment banks can periodically produce 

a mad momentum that sometimes leads to a lemmings-like race over the cliff. 58
63 

C.D.O. issuer worldwide by 2007, issuing in that year some $49.3 billion out of a worldwide total 

of $442.3 billion (or slightly over 11 percent of the world volume). Id. at 35. 

What motivated this extreme risk-taking? Certain of the managers running Citigroup’s securitization business received compensation as high as $34 million per year (even though they 

were not among the most senior officers of the bank). Id. at 34. This is consistent with the earlier diagnosis that equity compensation inclines management to accept higher and arguably excessive risk. At the highest level of Citigroup’s management, the New York Times reports that 

the primary concern was ‘‘that Citigroup was falling behind rivals like Morgan Stanley and 

Goldman.’’ Id. at 34 (discussing Robert Rubin and Charles Prince’s concerns). Competitive pressure is, of course, enforced by the stock market and Wall Street’s short-term system of bonus 

compensation. The irony then is that a rational strategy of deleveraging cannot be pursued by 

making boards and managements more sensitive to shareholder desires. 59From 1996 to 1999, the settlements in securities class actions totaled only $1.7 billion; thereafter, aggregate settlements rose exponentially, hitting a peak of $17.1 billion in 2006 

alone. See Laura Simmons & Ellen Ryan, ‘‘Securities Class Action Settlements: 2006, Review 

and Analysis’’ (Cornerstone Research 2006) at 1. This decline of due diligence practices as liability correspondingly increased seems paradoxical, but may suggest that at least private civil liability does not effectively deter issuers or underwriters. 60For a chart showing the growth of asset-backed securities in relation to conventional corporate debt issuances over recent years, see J. Coffee, J. Seligman, and H. Sale, SECURITIES 

REGULATION: Case and Materials (10th ed. 2006) at p. 10. 61For a detailed description of Merrill, Lynch’s late entry into the asset-backed securitization 

field and its sometimes frenzied attempt to catch up with Lehman by acquiring originators of 

mortgage loans, see Gretchen Morgenson, ‘‘How the Thundering Herd Faltered and Fell,’’ New 

York Times, November 9, 2008, at BU-1. Merrill eventually acquired an inventory of $71 billion 

in risky mortgages, in part through acquisitions of loan originators. By mid-2008, an initial 

writedown of $7.9 billion forced the resignation of its CEO. As discussed in this New York Times 

article, loan originators dealing with Merrill believed it did not accurately understand the risks 

of their field. For Lehman’s similar approach to acquisitions of loan originators, see text and 

note, supra, at note 56. 

This in essence had happened in the period just prior to the 2000 dot.com bubble, 

and again during the accounting scandals of 2001–2002, and this process repeated 

itself during the subprime mortgage debacle. Once the market becomes hot, the 

threat of civil liability—either to the SEC or to private plaintiffs in securities class 

actions—seems only weakly to constrain this momentum. Rationalizations are always available: ‘‘real estate prices never fall;’’ ‘‘the credit rating agencies gave this 

deal a ‘Triple A’ rating,’’ etc. Explosive growth and a decline in professional standards often go hand in hand. Here, after 2000, due diligence standards appear to 

have been relaxed, even as the threat of civil liability in private securities litigation 

was growing. 59

As an explanation for an erosion in professional standards, competitive pressure 

applies with particular force to those investment banks that saw asset-back 

securitizations as the core of their future business model. In 2002, a critical milestone was reached, as in that year the total amount of debt securities issued in 

asset-backed securitizations equaled (and then exceeded in subsequent years) the 

total amount of debt securities issued by public corporations. 60 Debt securitizations 

were not only becoming the leading business of Wall Street, as a global market of 

debt purchasers was ready to rely on investment grade ratings from the major credit rating agencies, but they were particularly important for the independent investment banks in the CSE Program. 

Although all underwriters anticipated high rates of return from securitizations, 

the independent underwriters had gradually been squeezed out of their traditional 

line of business—underwriting corporate securities—in the wake of the step-by-step 

repeal of the Glass-Steagall Act. Beginning well before the formal repeal of that Act 

in 1999, the major commercial banks had been permitted to underwrite corporate 

debt securities and had increasingly exploited their larger scale and synergistic ability to offer both bank loans and underwriting services to gain an increasing share 

of this underwriting market. Especially for the smaller investment banks (e.g., Bear 

Stearns and Lehman), the future lay in new lines of business, where, as nimble and 

adaptive competitors, they could steal a march on the larger and slower commercial 

banks. To a degree, both did, and Merrill eagerly sought to follow in their wake. 61

To stake out a dominant position, the CEOs of these firms adopted a ‘‘Damn-thetorpedoes-full-speed-ahead’’ approach that led them to make extremely risky acquisitions. Their common goal was to assure themselves a continuing source of supply 

of subprime mortgages to securitize, but in pursuit of this goal, both Merrill Lynch 

and Lehman made risky acquisitions, in effect vertically integrating into the mortgage loan origination field. These decisions, plus their willingness to acquire mortgage portfolios well in advance of the expected securitization transaction, left them 

undiversified and exposed to large writedowns when the real estate market soured. 
64 

62The Department of the Treasury, Blueprint for Modernized Financial Regulatory Structure 

(2008) (hereinafter, ‘‘Blueprint’’). 63 Id. at 4 and 27. 64The Conference Report to the Gramm-Leach-Bliley Act clearly states this: Both the House 

and Senate bills generally adhere to the principle of functional regulation, which holds that 

similar activities should be regulated by the same regulator. Different regulators have expertise 

at supervising different activities. It is inefficient and impractical to expect a regulator to have 

or develop expertise in regulating all aspects of financial services. H.R. Rep. No. 106-434, at 157 

(1999), reprinted in 1999 U.S.C.C.A.N. 1252. 65For this same assessment, see Heidi Mandanis Schooner & Michael Taylor, United Kingdom and United States Responses to the Regulatory Challenges of Modern Financial Markets, 

38 Tex. Int’l L. J. 317, 328 (2003). 66See 15 U.S.C. § 78o-5(a)(1)(B), 15 U.S.C. § 78(c)(a)(34)(G), and 15 U.S.C. § 78o-5(g)(2). 67See 15 U.S.C. § 78(c)(a)(4),(5). 68See Kathleen Day, Regulators Battle Over Banks: 3 Agencies Say SEC Rules Overstep Securities-Trading Law, Wash. Post, July 3, 2001, at E3. Eventually, the SEC backed down in this 

particular skirmish and modified its original position. See Securities Exch. Act Release No. 34- 

44570 (July 18, 2001) and Securities Exchange Age Release No. 34-44291, 66 Fed. Reg. 27760 

(2001). 

Regulatory Modernization: What Should Be Done? 

An Overview of Recent Developments 

Financial regulation in the major capital markets today follows one of three basic 

organizational models: 

The Functional/Institutional Model: In 2008, before the financial crisis truly 

broke, the Treasury Department released a major study of financial regulation in 

the United States. 62 This document (known as the ‘‘Blueprint’’) correctly characterized the United States as having a ‘‘current system of functional regulation, which 

maintains separate regulatory agencies across segregated functional lines of financial services, such as banking, insurance, securities, and futures.’’ 63 Unfortunately, 

even this critical assessment may understate the dimensions of this problem of fragmented authority. In fact, the U.S. falls considerably short of even a ‘‘functional’’ 

regulatory model. By design, ‘‘functional’’ regulation seeks to subject similar activities to regulation by the same regulator. Its premise is that no one regulator can 

have, or easily develop, expertise in regulating all aspects of financial services. 

Thus, the securities regulator understands securities, while the insurance regulator 

has expertise with respect to the very different world of insurance. In the GrammLeach-Bliley Act of 1999 (‘‘GLBA’’), which essentially repealed the Glass-Steagall 

Act, Congress endorsed such a system of functional regulation. 64

Nonetheless, the reality is that the United States actually has a hybrid system 

of functional and institutional regulation. 65 The latter approach looks not to functional activity, but to institutional type. Institutional regulation is seldom the product of deliberate design, but rather of historical contingency, piecemeal reform, and 

gradual evolution. 

To illustrate this difference between functional and institutional regulation, let us 

hypothesize that, under a truly functional system, the securities regulator would 

have jurisdiction over all sales of securities, regardless of the type of institution selling the security. Conversely, let us assume that under an institutional system, jurisdiction over sales would be allocated according to the type of institution doing the 

selling. Against that backdrop, what do we observe today about the allocation of jurisdiction? Revealingly, under a key compromise in GLBA, the SEC did not receive 

general authority to oversee or enforce the securities laws with respect to the sale 

of government securities by a bank. 66 Instead, banking regulators retained that authority. Similarly, the drafters of the GLBA carefully crafted the definitions of 

‘‘broker’’ and ‘‘dealer’’ in the Securities Exchange Act of 1934 to leave significant 

bank securities activities under the oversight of bank regulators and not the SEC. 67

Predictably, even in the relatively brief time since the passage of GLBA in 1999, 

the SEC and bank regulators have engaged in a continuing turf war over the scope 

of the exemptions accorded to banks from the definition of ‘‘broker’’ and ‘‘dealer.’’ 68

None of this should be surprising. The status quo is hard to change, and regulatory bodies do not surrender jurisdiction easily. As a result, the regulatory body 

historically established to regulate banks will predictably succeed in retaining much 

of its authority over banks, even when banks are engaged in securities activities 

that from a functional perspective should belong to the securities regulator. 

‘‘True’’ functional regulation would also assign similar activities to one regulator, 

rather than divide them between regulators based on only nominal differences in 

the description of the product or the legal status of the institution. Yet, in the case 

of banking regulation, three different federal regulators oversee banks: the Office of 

the Controller of the Currency (‘‘OCC’’) supervises national banks; the Federal Re-
65 

69This is all well described in the Blueprint. See Blueprint, supra note 62, at 31–41. 70 Blueprint, supra note 62, at 4. 71 In particular, the Blueprint hypothesizes that the U.K. has enhanced its own competitiveness by regulatory reforms, adopted in 2000, that are principles-based and rely on self regulation for their implementation. Id. at 3. 72For recent overviews, see Ellis Ferran, Symposium: Do Financial Supermarkets Need 

Super-Regulators? Examining the United Kingdom’s Experience in Adopting the Single Financial Regulator Model, 28 Brook. J. Int’l L. 257, 257–59 (2003); Jerry W. Markham, A Comparative Analysis of Consolidated and Functional Regulation: Super Regulator: A Comparative Analysis of Securities and Derivative Regulation in the United States, the United Kingdom, and 

Japan, 28 Brook. J. Int’l L. 319, 319–20 (2003); Giorgio Di Giorgio & Carmine D. Noia, Financial 

Market Regulation and Supervision: How Many Peaks for the Euro Area?, 28 Brook. J. Int’l L. 

463, 469–78 (2003). 73 Norway moved to an integrated regulatory agency in 1986, followed by Denmark in 1988, 

and Sweden in 1991. See D. Giorgio & D. Noia, supra note 72, at 469–478. 

serve Board (‘‘FRB’’) oversees state-chartered banks that are members of the Federal Reserve System and the Federal Deposit Insurance Corporation (‘‘FDIC’’) supervises state-chartered banks that are not members of the Federal Reserve System 

but are federally insured. 69 Balkanization does not stop there. The line between 

‘‘banks,’’ with their three different regulators at the federal level, and ‘‘thrifts,’’ 

which the Office of Thrift Supervision (‘‘OTS’’) regulates, is again more formalistic 

than functional and reflects a political compromise more than a difference in activities. 

Turning to securities regulation, one encounters an even stranger anomaly: the 

United States has one agency (the SEC) to regulate securities and another (the 

Commodities Future Trading Commission (CFTC)) to regulate futures. The world of 

derivatives is thereby divided between the two, with the SEC having jurisdiction 

over options, while the CFTC has jurisdiction over most other derivatives. No other 

nation assigns futures and securities regulation to different regulators. For a time, 

the SEC and CFTC both asserted jurisdiction over a third category of derivatives— 

swaps—but in 2000 Congress resolved this dispute by placing their regulation largely beyond the reach of both agencies. Finally, some major financial sectors (for example, insurance and hedge funds) simply have no federal regulator. By any standard, the United States thus falls well short of a true system of functional regulation, 

because deregulation has placed much financial activity beyond the reach of any federal regulator. 

Sensibly, the Blueprint proposes to rationalize this patchwork-quilt structure of 

fragmented authority through the merger and consolidation of agencies. Specifically, 

it proposes both a merger of the SEC and CFTC and a merger of the OCC and the 

OTS. Alas, such mergers are rarely politically feasible, and to date, no commentator 

(to our knowledge) has predicted that these proposed mergers will actually occur. 

Thus, although the Blueprint proposes that we move beyond functional regulation, 

the reality is that we have not yet approached even a system of functional regulation, as our existing financial regulatory structure is organized at least as much by 

institutional category as by functional activity. Disdaining a merely ‘‘functional’’ reorganization under which banking, insurance, and securities would each be governed by their own federal regulator, the Blueprint instead envisions a far more 

comprehensive consolidation of all these specialized regulators. Why? In its view, 

the problems with functional regulation are considerable: 

A functional approach to regulation exhibits several inadequacies, the most significant being the fact that no single regulator possesses all the information and authority necessary to monitor systemic risk, or the potential that events associated 

with financial institutions may trigger broad dislocation or a series of defaults that 

affect the financial system so significantly that the real economy is adversely affected. 70

But beyond these concerns about systemic risk, the architects of the Blueprint 

were motivated by a deeper anxiety: regulatory reform is necessary to maintain the 

capital market competitiveness of the United States. 71 In short, the Blueprint is designed around two objectives: (1) the need to better address systemic risk and the 

possibility of a cascading series of defaults, and (2) the need to enhance capital market competitiveness. As discussed later, the first concern is legitimate, but the second involves a more dubious logic. 

The Consolidated Financial Services Regulator: A clear trend is today evident towards the unification of supervisory responsibilities for the regulation of banks, securities markets and insurance. 72 Beginning in Scandinavia in the late 1980s, 73

this trend has recently led the United Kingdom, Japan, Korea, Germany and much 
66 

74See Bryan D. Stirewalt & Gary A. Gegenheimer, Consolidated Supervision of Banking 

Groups in the Former Soviet Republics: A Comparative Examination of the Emerging Trend in 

Emerging Markets, 23 Ann. Rev. Banking & Fin. L. 533, 548–49 (2004). As discussed later, in 

some countries (most notably Japan), the change seems more one of form than of substance, 

with little in fact changing. See Markham, supra note 72, at 383–393, 396. 75See Ferran, supra note 72, at 258. 76See Schooner & Taylor, supra note 65, at 329. Schooner and Taylor also observe that the 

precursors to the U.K.’s centralized regulator, which were mainly in Scandinavia, had a ‘‘predominantly prudential focus.’’ Id. at 331. That is, the unified new regulator was more a guardian 

of ‘‘safety and soundness’’ and less oriented toward consumer protection. 77 Blueprint, supra note 62 at 3. 78Ferran, supra note 72, at 259. 79 Id. at 261–262. 80 Id. at 265. 81 Id. at 266. The most important of these were the Securities and Futures Authority (SFA), 

the Investment Managers’ Regulatory Organization (IMRO), and the Personal Investment Authority (PIA). 82Two scandals in particular stood out: the Robert Maxwell affair in which a prominent financier effectively embezzled the pension funds of his companies and a ‘‘pension mis-selling’’ controversy in which highly risky financial products were inappropriately sold to pension funds 

without adequate supervision or disclosure. Id. at 267–268. 83 Id. at 268. 84See infra notes—and accompanying text. 

of Eastern Europe to move to a single regulator model. 74 Although there are now 

a number of precedents, the U.K. experience stands out as the most influential. It 

was the first major international market center to move to a unified regulator 

model, 75 and the Financial Services and Markets Act, adopted in 2000, went significantly beyond earlier precedents towards a ‘‘nearly universal regulator.’’ 76 The Blueprint focuses on the U.K.’s experience because it believes that the U.K.’s adoption 

of a consolidated regulatory structure ‘‘enhanced the competitiveness of the U.K. 

economy.’’ 77

Yet it is unclear whether the U.K.’s recent reforms provide a legitimate prototype 

for the Blueprint’s proposals. Here, the Blueprint may have doctored its history. By 

most accounts, the U.K.’s adoption of a single regulator model was ‘‘driven by country-specific factors,’’ 78 including the dismal failure of a prior regulatory system that 

relied heavily on self-regulatory bodies but became a political liability because of its 

inability to cope with a succession of serious scandals. Ironically, the financial history of the U.K. in the 1990s parallels that of the United States over the last decade. On the banking side, the U.K. experienced two major banking failures—the 

Bank of Credit and Commerce International (‘‘BCCI’’) in 1991 and Barings in 1995. 

Each prompted an official inquiry that found lax supervision was at least a partial 

cause. 79

Securities regulation in the U.K. came under even sharper criticism during the 

1990s because of a series of financial scandals that were generally attributed to an 

‘‘excessively fragmented regulatory infrastructure.’’ 80 Under the then applicable law 

(the Financial Services Act of 1986), most regulatory powers were delegated to the 

Securities and Investments Board (SIB), which was a private body financed through 

a levy on market participants. However, the SIB did not itself directly regulate. 

Rather, it ‘‘set the overall framework of regulation,’’ but delegated actual authority 

to second tier regulators, which consisted primarily of self-regulatory organizations 

(SROs). 81 Persistent criticism focused on the inability or unwillingness of these 

SROs to protect consumers from fraud and misconduct. 82 Ultimately, the then 

chairman of the SIB, the most important of the SROs, acknowledged that self-regulation had failed in the U.K. and seemed unable to restore investor confidence. 83

This acknowledgement set the stage for reform, and when a new Labour Government came into power at the end of the decade, one of its first major legislative acts 

(as it had promised in its election campaign) was to dismantle the former structure 

of SROs and replace it with a new and more powerful body, the Financial Services 

Authority (FSA). 

Despite the Blueprint’s enthusiasm for the U.K.’s model, the structure that the 

Blueprint proposes for the U.S. more closely resembles the former U.K. system than 

the current one. Under the Blueprint’s proposals, the securities regulator would be 

restricted to adopting general ‘‘principles-based’’ policies, which would be implemented and enforced by SROs. 84 Ironically, the Blueprint relies on the U.K. experience to endorse essentially the model that the U.K. concluded had failed. 

The ‘‘Twin Peaks’’ Model: As the Blueprint recognizes, not all recent reforms have 

followed the U.K. model of a universal regulator. Some nations—most notably Australia and the Netherlands—instead have followed a ‘‘twin peaks’’ model that places 

responsibility for the ‘‘prudential regulation of relevant financial institutions’’ in one 
67 

85 Blueprint, supra note 62, at 3. For a recent discussion of the Australian reorganization, 

which began in 1996 (and thus preceded the U.K.), see Schooner & Taylor, supra note65, at 

340–341. The Australian Securities and Investments Commission (ASIC) is the ‘‘consumer protection’’ agency under this ‘‘twin peaks’’ approach, and the Australian Prudential Regulatory Authority (APRA) supervises bank ‘‘safety and soundness.’’ Still, the ‘‘twin peaks’’ model was not 

fully accepted in Australia as ASIC, the securities regulator, does retain supervisory jurisdiction 

over the ‘‘financial soundness’’ of investment banks. Thus, some element of functional regulation 

remains. 86Michael Taylor, Twin Peaks: A Regulatory Structure for the New Century i (Centre for the 

Study of Financial Institutions 1995). For a brief review of Taylor’s work, see Cynthia Crawford 

Lichtenstein, The Fed’s New Model of Supervision for ‘‘Large Complex Banking Organizations’’: 

Coordinated Risk-Based Supervision of Financial Multinationals for International Financial Stability, 18 Transnat’l Law. 283, 295–296 (2005). 87Lichtenstein, supra note 86, at 295; Taylor, supra note 86, at 4. 88See Coffee, Law and the Market: The Impact of Enforcement, 156 U. of Pa. L. Rev. 299 

(2007) (discussing average annual SEC penalties and class action settlements). 89See Richard Booth, The End of the Securities Fraud Class Action as We Know It, 4 Berkeley Bus. L. J. 1, at 3 (2007). 90See Financial Services and Markets Act, 2000, c. 8, pt. 1, 6, http://www.opsi.gov.uk/ 

ACTS/acts2000/pdf/ukpgal20000008len.pdf 91See Schooner & Taylor, supra note 65, at 335. 92 Id. 

agency and supervision of ‘‘business conduct and consumer protection’’ in another. 85

The term ‘‘twin peaks’’ derives from the work of Michael Taylor, a British academic 

and former Bank of England official. In 1995, just before regulatory reform became 

a hot political issue in the U.K., he argued that financial regulation had two separate basic aims (or ‘‘twin peaks’’): (1) ‘‘to ensure the soundness of the financial system,’’ and (2) ‘‘to protect consumers from unscrupulous operators.’’ 86 Taylor’s work 

was original less in its proposal to separate ‘‘prudential’’ regulation from ‘‘business 

conduct’’ regulation than in its insistence upon the need to consolidate ‘‘responsibility for the financial soundness of all major financial institutions in a single agency.’’ 87 Taylor apparently feared that if the Bank of England remained responsible 

for the prudential supervision of banks, its independence in setting interest rates 

might be compromised by its fear that raising interest rates would cause bank failures for which it would be blamed. In part for this reason, the eventual legislation 

shifted responsibility for bank supervision from the Bank of England to the FSA. 

The Blueprint, itself, preferred a ‘‘twin peaks’’ model, and that model is far more 

compatible with the U.S.’s current institutional structure for financial regulation. 

But beyond these obvious points, the best argument for a ‘‘twin peaks’’ model involves conflict of interests and the differing culture of banks and securities regulators. It approaches the self-evident to note that a conflict exists between the consumer protection role of a universal regulator and its role as a ‘‘prudential’’ regulator intent on protecting the safety and soundness of the financial institution. The 

goal of consumer protection is most obviously advanced through deterrence and financial sanctions, but these can deplete assets and ultimately threaten bank solvency. When only modest financial penalties are used, this conflict may sound more 

theoretical than real. But, the U.S. is distinctive in the severity of the penalties it 

imposes on financial institutions. In recent years, the SEC has imposed restitution 

and penalties exceeding $3 billion annually, and private plaintiffs received a record 

$17 billion in securities class action settlements in 2006. 88 Over a recent ten year 

period, some 2,400 securities class actions were filed and resulted in settlements of 

over $27 billion, with much of this cost (as in the Enron and WorldCom cases) being 

borne by investment banks. 89 If one agency were seeking both to protect consumers 

and guard the solvency of major financial institutions, it would face a difficult balancing act to achieve deterrence without threatening bank solvency, and it would 

risk a skeptical public concluding that it had been ‘‘captured’’ by its regulated firms. 

Even in jurisdictions adopting the universal regulator model, the need to contemporaneously strengthen enforcement has been part of the reform package. Although 

the 2000 legislation in the U.K. did not adopt the ‘‘twin peaks’’ format, it did significantly strengthen the consumer protection role of its centralized regulator. The 

U.K.’s Financial Services and Markets Act, enacted in 2000, sets out four statutory 

objectives, with the final objective being the ‘‘reduction of financial crime.’’ 90 According to Heidi Schooner and Michael Taylor, this represented ‘‘a major extension of 

the FSA’s powers compared to the agencies it replaced,’’ 91 and it reflected a political 

response to the experience of weak enforcement by self-regulatory bodies, which had 

led to the creation of the FSA. 92 With probably unintended irony, Schooner and 

Taylor described this new statutory objective of reducing ‘‘financial crime’’ as the 

‘‘one aspect of U.K. regulatory reform in which its proponents seem to have drawn 
68 

93 Id. at 335–36. 94 Japan has a history and a regulatory culture of economic management of its financial institutions through regulatory bodies that is entirely distinct from that of Europe or the United 

States. Although it has recently created a Financial Services Agency, observers contend that it 

remains committed to its traditional system of bureaucratic regulation that supports its large 

banks and discourages foreign competition. See Markham, supra note 72, at 383–92, 396. Nonetheless, scandals have been the primary force driving institutional change there too, and Japan’s 

FSA was created at least in part because Japan’s Ministry of Finance (MOF) had become embarrassed by recurrent scandals. 95See Jonathan Macey, Organizational Design and Political Control of Administrative Agencies, 8 J. Law, Economics, and Organization 93 (1992). It can, of course, be argued which agency 

is more ‘‘single purpose’’ (the SEC or the Federal Reserve), but the latter does deal with a broader class of institutions in terms of their capital adequacy. 

direct inspiration from U.S. law and practice.’’ 93 Conspicuously, the Blueprint ignores that ‘‘modernizing’’ financial regulation in other countries has generally meant 

strengthening enforcement. 

A Preliminary Evaluation: Three preliminary conclusions merit emphasis: 

First, whether the existing financial regulatory structure in the United States is 

considered ‘‘institutional’’ or ‘‘functional’’ in design, its leading deficiency seems evident: it invites regulatory arbitrage. Financial institutions position themselves to 

fall within the jurisdiction of the most accommodating regulator, and investment 

banks design new financial products so as to encounter the least regulatory oversight. Such arbitrage can be defended as desirable if one believes that regulators 

inherently overregulate, but not if one believes increased systemic risk is a valid 

concern (as the Blueprint appears to believe). 

Second, the Blueprint’s history of recent regulatory reform involves an element of 

historical fiction. The 2000 legislation in the U.K., which created the FSA as a nearly universal regulator, was not an attempt to introduce self-regulation by SROs, as 

the Blueprint seems to assume, but a sharp reaction by a Labour Government to 

the failures of self-regulation. Similarly, Japan’s slow, back-and-forth movement in 

the direction of a single regulator seems to have been motivated by an unending 

series of scandals and a desire to give its regulator at least the appearance of being 

less industry dominated. 94

Third, the debate between the ‘‘universal’’ regulator and the ‘‘twin peaks’’ alternative should not obscure the fact that both are ‘‘superregulators’’ that have moved 

beyond ‘‘functional’’ regulation on the premise that, as the lines between banks, securities dealers, and insurers blur, so regulators should similarly converge. That 

idea will and should remain at the heart of the U.S. debate, even after many of the 

Blueprint’s proposals are forgotten. 

Defining the Roles of the ‘‘Twin Peaks’’ (Systemic Risk Regulator and Consumer Protector)—Who Should Do What? 

The foregoing discussion has suggested why the SEC would not be an effective 

risk regulator. It has neither the specialized competence nor the organizational culture for the role. Its comparative advantage is enforcement, and thus its focus 

should be on transparency and consumer protection. Some also argue that ‘‘single 

purpose’’ agencies, such as the SEC, are more subject to regulatory capture than are 

broader or ‘‘general purpose’’ agencies. 95 To the extent that the Federal Reserve 

would have responsibility for all large financial institutions and would be expected 

to treat monitoring their capital adequacy and risk management practices as among 

its primary responsibilities, it does seem less subject to capture, because any failure 

would have high visibility and it would bear the blame. Still, this issue is largely 

academic because the SEC no longer has responsibility over any investment banks 

of substantial size. 

The real issue then is defining the relationships between the two peaks so that 

neither overwhelms the other. 

The Systemic Risk Regulator (SRR): Systemic risk is most easily defined as the 

risk of an inter-connected financial breakdown in the financial system—much like 

the proverbial chain of falling dominoes. The closely linked insolvencies of Lehman, 

AIG, Fannie Mae and Freddie Mac in the Fall of 2008 present a paradigm case. 

Were they not bailed out, other financial institutions were likely to have also failed. 

The key idea here is not that one financial institution is too big to fail, but rather 

that some institutions are too interconnected to permit any of them to fail, because 

they will drag the others down. 

What should a system risk regulator be authorized to do? Among the obvious powers that it should have are the following: 

a. Authority To Limit the Leverage of Financial Institutions and Prescribe Mandatory Capital Adequacy Standards. This authority would empower the SRR to pre-
69 

scribe minimum levels of capital and ceilings on leverage for all categories of financial institutions, including banks, insurance companies, hedge funds, money market 

funds, pension plans, and quasi-financial institutions (such as, for example, G.E. 

Capital). The standards would not need to be identical for all institutions and 

should be risk adjusted. The SRS should be authorized to require reductions in debt 

to equity ratios below existing levels, to consider off-balance sheet liabilities (including those of partially owned subsidiaries and also contractual agreements to repurchase or guarantee) in computing these tests and ratios (even if generally accepted 

accounting principles would not require their inclusion). 

The SRR would focus its monitoring on the largest institutions in each financial 

class, leaving small institutions to be regulated and monitored by their primary regulator. For example, the SEC might require all hedge funds to register with it under 

the Investment Advisers Act of 1940, but hedge funds with a defined level of assets 

(say, $25 billion in assets) would be subject to the additional and overriding authority of the SSR. 

b. Authority To Approve, Restrict and Regulate Trading in New Financial Products. By now, it has escaped no one’s attention that one particular class of over-thecounter derivative (the credit default swap) grew exponentially over the last decade 

and was outside the jurisdiction of any regulatory agency. This was not accidental, 

as the Commodities Futures Modernization Act of 2000 deliberately placed over-thecounter derivatives beyond the general jurisdiction of both the SEC and the CFTC. 

The SRR would be responsible for monitoring the growth of new financial products 

and would be authorized to regulate such practices as the collateral or margin that 

counter-parties were required to post. Arguably, the SRR should be authorized to 

limit those eligible to trade such instruments and could bar or restrict the purchase 

of ‘‘naked’’ credit default swaps (although the possession of this authority would not 

mean that the SRR would have to exercise it, unless it saw an emergency developing). 

c. Authority To Mandate Clearing Houses. Securities and options exchanges uniformly employ clearing houses to eliminate or mitigate credit risk. In contrast, when 

an investor trades in an over-the-counter derivative, it must accept both market risk 

(the risk that the investment will sour or price levels will change adversely) and 

credit risk (the risk that the counterparty will be unable to perform). Credit risk 

is the factor that necessitated the bailout of AIG, as its failure could have potentially led to a cascade of failures by other financial institutions if it defaulted on 

its swaps. Use of the clearing house should eliminate the need to bail out a future 

AIG because its responsibilities would fall on the clearing house to assume and the 

clearing house would monitor and limit the risk that its members assumed. 

At present, several clearinghouses are in the process of development in the United 

States and Europe. The SRR would be the obvious body to oversee such clearing 

houses (and indeed the Federal Reserve was already instrumental in their formation). Otherwise, some clearing houses are likely to be formed under the SEC’s supervision and some under the CFTC’s, thus again permitting regulatory arbitrage 

to develop. 

A final and complex question is whether competing clearing houses are desirable 

or whether they should be combined into a single centralized clearing house. This 

issue could also be given to the SRR. 

d. Authority To Mandate Writedowns for Risky Assets. A real estate bubble was 

the starting point for the 2008 crisis. When any class of assets appreciates meteorically, the danger arises that on the eventual collapse in that overvalued market, the 

equity of the financial institution will be wiped out (or at the least so eroded as to 

create a crisis in investor confidence that denies that institution necessary financing). This tendency was palpably evident in the failure of Bear Stearns, Lehman, 

Fannie Mae and Freddie Mac. If the SRR regulator relies only on debt/equity ratios 

to protect capital adequacy, they will do little good and possibly provide only illusory 

protections. Any financial institution that is forced to writedown its investment in 

overpriced mortgage and real estate assets by 50 percent will necessarily breach 

mandated debt to equity ratios. The best answer to this problem is to authorize the 

SRR to take a proactive and countercyclical stance by requiring writedowns in risky 

asset classes (at least for regulatory purposes) prior to the typically much later point 

at which accountants will require such a writedown. 

Candidly, it is an open question whether the SRS, the Federal Reserve, or any 

banking regulator would have the courage and political will to order such a 

writedown (or impose similar restraints on further acquisitions of such assets) while 

the bubble was still expanding. But Congress should at least arm its regulators with 

sufficient power and direct them to use it with vigor. 

e. Authority To Intervene To Prevent and Avert Liquidity Crises. Financial institutions often face a mismatch between their assets and liabilities. They may invest 
70 

in illiquid assets or make long-term loans, but their liabilities consist of short-term 

debt (such as commercial paper). Thus, regulating leverage ratios is not alone adequate to avoid a financial crisis, because the institution may suddenly experience 

a ‘‘run’’ (as its depositors flee) or be unable to roll over its commercial paper or other 

short-term debt. This problem is not unique to banks and can be encountered by 

hedge funds and private equity funds (as the Long Term Capital Management crisis 

showed). The SRR thus needs the authority to monitor liquidity problems at large 

financial institutions and direct institutions in specific cases to address such imbalances (either by selling assets, raising capital, or not relying on short-term debt). 

From the foregoing description, it should be obvious that the only existing agency 

in a position to take on this assignment and act as an SRR is the Federal Reserve 

Board. But it is less politically accountable than most other federal agencies, and 

this could give rise to some problems discussed below. 

The Consumer Protection and Transparency Agency: The creation of an SSR would 

change little at the major Federal agencies having responsibilities for investor protection. Although it might be desirable to merge the SEC and the CFTC, this is not 

essential. Because no momentum has yet developed for such a merger, I will not 

discuss it further at this time. 

Currently, there are over 5,000 broker-dealers registered with the SEC. They 

would remain so registered, and the SRR would concern itself only with those few 

whose potential insolvency could destabilize the markets. The focus of the SEC’s 

surveillance of broker-dealers is on consumer protection and market efficiency, and 

this would not be within the expertise of the Federal Reserve or any other potential 

SRR. 

The SEC is also an experienced enforcement agency, while the Federal Reserve 

has little, if any, experience in this area. Further, the SEC understands disclosure 

issues and is a champion of transparency, whereas banking regulators start from 

the unstated premise that disclosures of risks or problems at a financial institution 

is undesirable because it might provoke a ‘‘run’’ on the bank. The SEC and the Controller of the Currency have long disagreed about what banks should disclose in the 

Management Discussion and Analysis that banks file with the SEC. Necessarily, 

this tension will continue. 

Resolving the Conflicts: The SEC and the PCAOB have continued to favor ‘‘mark 

to market’’ accounting, while major banks have sought relief from the write-downs 

that it necessitates. Suppose then that in the future a SRR decided that ‘‘mark to 

market’’ accounting increased systemic risk. Could it determine that financial institutions should be spared from such an accounting regime on the ground that it was 

pro-cyclical? This is an issue that Congress should address in any legislation authorizing a SRR or enhancing the powers of the Federal Reserve. I would recommend 

that Congress maintain authority in the SEC to determine appropriate accounting 

policies, because, put simply, transparency has been the core value underlying our 

system of securities regulation. 

But there are other areas where a SRR might well be entitled to overrule the 

SEC. Take, for example, the problem of short selling the stocks of financial institutions during a period of market stress. Although the SEC did ban short selling in 

financial stocks briefly in 2008, one can still imagine an occasion on which the SRR 

and the SEC might disagree. Here, transparency would not be an issue. Short selling is pro-cyclical, and a SRR could determine that it had the potential to destabilize and increase systemic risk. If it did so, its judgment should control. 

These examples are given only by way of illustration, and the inevitability of conflicts between the two agencies is not assumed. The President’s Working Group on 

Financial Markets has generally been able to work out disagreements through consultation and negotiation. Still, in any legislation, it would be desirable to identify 

those core policies (such as transparency and full disclosure) that the SRR could not 

override. 

The Failure of Quantitative Models: If one lesson should have been learned 

from the 2008 crisis, it is that quantitative models, based on historical data, eventually and inevitably fail. Rates of defaults on mortgages can change (and swiftly), and 

housing markets do not invariably rise. In the popular vernacular, ‘‘black swans’’ 

both can occur and even become predominant. This does not mean that quantitative 

models should not be used, but that they need to be subjected to qualitative and 

judgmental overrides. 

The weakness in quantitative models is particularly shown by the extraordinary 

disparity between the value at risk estimates (VaRs) reported by underwriters to 

the SEC and their eventual writedowns for mortgage-backed securities. Ferrell, 

Bethel and Hu report that for a selected group of major financial institutions the 

average ratio of asset writedowns as of August 20, 2008, to VaRs reported for 2006 
71 

96See Farrell, Bethel, and Hu, supra note 15, at 47. 97See Section 17(e)(1) of the Securities Exchange Act of 1934, 15 U.S.C. § 78(q)(e)(1). 98See, e.g., Securities Exch. Act Rel. No. 34-54920 (Dec. 12, 2006). 99See Rule 206(4)-2 (‘‘Custody of Funds or Securities of Clients By Investment Advisers’’), 17 

CFR § 275.206(4)-2. 

was 291 to 1. 96 If financial institutions cannot accurately estimate their exposure 

for derivatives and risky assets, this undermines many of the critical assumptions 

underlying the Basel II Accords, and suggests that regulators cannot defer to the 

institutions’ own risk models. Instead, they must reach their own judgments, and 

Congress should so instruct them. 

The Lessons of Madoff: Implications for the SEC, FINRA, and SIPC 

No time need be wasted pointing out that the SEC missed red flags and overlooked credible evidence in the Madoff scandal. Unfortunately, most Ponzi schemes 

do not get detected until it is too late. This implies that an ounce of prevention may 

be worth several pounds of penalties. More must be done to discourage and deter 

such schemes ex ante, and the focus cannot be only on catching them ex post. 

From this perspective focused on prevention, rather than detection, the most obvious lesson is that the SEC’s recent strong tilt towards deregulation contributed to, 

and enabled, the Madoff fraud in two important respects. First, Bernard L. Madoff 

Investment Securities LLC (BMIS) was audited by a fly-by-night auditing firm with 

only one active accountant who had neither registered with the Public Company Accounting Oversight Board (‘‘PCAOB’’) nor even participated in New York State’s 

peer review program for auditors. Yet, the Sarbanes-Oxley Act required broker-dealers to use a PCAOB-registered auditor. 97 Nonetheless, until the Madoff scandal exploded, the SEC repeatedly exempted privately held broker-dealers from the obligation to use such a PCAOB-registered auditor and permitted any accountant to suffice. 98 Others also exploited this exemption. For example, in the Bayou Hedge Fund 

fraud, which was the last major Ponzi scheme before Madoff, the promoters simply 

invented a fictitious auditing firm and forged certifications in its name. Had auditors been required to have been registered with PCAOB, this would not have been 

feasible because careful investors would have been able to detect that the fictitious 

firm was not registered. 

Presumably, the SEC’s rationale for this overbroad exemption was that privately 

held broker-dealers did not have public shareholders who needed protection. True, 

but they did have customers who have now been repeatedly victimized. At the end 

of 2008, the SEC quietly closed the barn door by failing to renew this exemption— 

but only after $50 billion worth of horses had been stolen. 

A second and even more culpable SEC mistake continues to date. Under the Investment Advisers Act, investment advisers are required to maintain client funds 

or securities with a ‘‘qualified custodian.’’ 99 In principle, this requirement should 

protect investors from Ponzi schemes, because an independent custodian would not 

permit the investment adviser to have access to the investors’ funds. Indeed, for exactly this reason, mutual funds appear not to have experienced Ponzi-style frauds, 

which have occurred only in the case of hedge funds and investment advisers. Under 

Section 17(f) of the Investment Company Act, mutual funds must use a separate 

custodian. But in the case of investment advisors, the SEC permits the investment 

adviser to use an affiliated broker-dealer or bank as its qualified custodian. Thus, 

Madoff could and did use BMIS, his broker dealer firm, to serve as custodian for 

his investment adviser activities. The net result is that only a very tame watchdog 

monitors the investment adviser. Had an independent and honest custodian held 

the investors’ funds, Madoff could not have recycled new investors’ contributions to 

earlier investors, and the custodian would have noticed that Madoff was not actually 

trading. Other recent Ponzi schemes seem to have similarly sidestepped the need 

for an independent custodian. At Senate Banking Committee hearings on the 

Madoff debacle this January, the director of the SEC’s Office of Compliance, Inspection and Examinations estimated that, out of the 11,300 investment advisers currently registered with the SEC, some 1,000 to 1,500 might similarly use an affiliated 

broker-dealer as their custodian. For investors, the SEC’s tolerance for selfcustodians makes the ‘‘qualified custodian’’ rule an illusory protection. 

At present, the Madoff scandal has so shaken investor confidence in investment 

advisors that even the industry trade group for investment advisers (the Investment 

Advisers Association) has urged the SEC to adopt a rule requiring investment advisers to use an independent custodian. Unfortunately, one cannot therefore assume 

that the SEC will quickly produce such a rule. The SEC’s staff knows that smaller 

investment advisers will oppose any rule that requires them to incur additional 

costs. Even if a reform rule is proposed, the staff may still overwhelm such a rule 
72 

100 17 CFR § 270.3a-7 (‘‘Issuers of Asset-Backed Securities’’). This exemption dates back to 

1992. 101 17 CFR § 229.1100 et seq. (‘‘Asset-Backed Securities’’). Regulation AB was adopted in 2005, 

but reflects an earlier pattern of exemptions in no-action letters. 

with exceptions (such as by permitting an independent custodian to use subcustodians who are affiliated with the investment adviser). Congress should therefore direct it to require an independent custodian, across the board for mutual 

funds, hedge funds, and investment advisers. 

The Madoff scandal exposes shortcomings not only at the SEC but elsewhere in 

related agencies. Over the last 5 years, the number of investment advisers has 

grown from roughly 7,500 to 11,300—more than one third. Given this growth, it is 

becoming increasingly anomalous that there is no self-regulatory body (SRO) for investment advisers. Although FINRA may have overstated in its claim that it had 

no authority to investigate Madoff’s investment adviser operations (because it could 

and should have examined BMIS’s performance as the ‘‘qualified custodian’’ for 

Madoff’s investment advisory activities), it still lacks authority to examine investment advisers. Some SRO (either FINRA or a new body) should have direct authority to oversee the investment adviser activities of an integrated broker-dealer firm. 

Similarly, the Securities Investor Protection Corporation (SIPC) continues to 

charge all broker-dealer firms the same nominal fee for insurance without any riskadjustment. Were it to behave like a private insurer and charge more to riskier 

firms for insurance, these firms would have a greater incentive to adopt better internal controls against fraud. A broker-dealer that acted as a self-custodian for a related investment adviser would, for example, pay a higher insurance commission. 

Also, if higher fees were charged, more insurance (which is currently capped at 

$500,000 per account) could be provided to investors. When all broker-dealers are 

charged the same insurance premium, this subsidizes the riskier firms—i.e., the future Madoffs of the industry. 

Finally, one of the most perplexing problems in the Madoff story is why, when 

the SEC finally forced Madoff to register as an investment adviser in 2006, it did 

not conduct an early examination of BMIS’s books and records. Red flags were flying, as Madoff (1) used an unknown accountant, (2) served as his own self-custodian, 

(3) had apparently billions of dollars in customer accounts, (4) had long resisted registration, and (5) was the subject of plausible allegations of fraud from credible 

whistle-blowers. Cost constrained as the SEC may have been, the only conclusion 

that can be reached here is that the SEC has poor criteria for evaluating the relative risk of investment advisers. At a minimum, Congress should require a report 

by the SEC as to the criteria used to determine the priority of examinations and 

how the SEC proposes to change those criteria in light of the Madoff scandal. 

Some have proposed eliminating the SEC’s Office of Compliance, Inspection and 

Examinations and combining its activities with the Division of Investment Management. I do not see this as a panacea. Rather, it simply reshuffles the cards. The 

real problem is the criteria used to determine who should be examined. Credible allegations of fraud need to be directed to the compliance inspectors. 

Asset-Backed Securitizations: What Failed? 

Asset-backed securitizations represent a financial technology that failed. As outlined earlier, this failure seems principally attributable to a ‘‘moral hazard’’ problem 

that arose under which both loan originators and underwriters relaxed their lending 

standards and packaged non-creditworthy loans into portfolios, because both found 

that they could sell these portfolios at a high profit and on a global basis—at least 

so long as the debt securities carried an investment grade credit rating from an 

NRSRO credit rating agency. 

Broad deregulatory rules contributed to this problem, and the two most important 

such SEC rules are Rules 3a-7 under the Investment Company Act 100 and Regulation AB. 101 Asset-backed securities (including CDOs) are typically issued by a special purpose vehicle (SPV) controlled by the promoter (which often may be an investment or commercial bank). This SPV would under ordinary circumstances be 

deemed an ‘‘investment company’’ and thus subjected to the demanding requirements of the Investment Company Act—but for Rule 3a-7. That rule exempts fixedincome securities issued by an SPV if, at the time of sale, the securities are rated 

in one of the four highest categories of investment quality by a ‘‘nationally recognized statistical rating organization’’ (NRSRO). In essence, the SEC has delegated 

to the NRSROs (essentially, at the time at least, Moody’s, S&P and Fitch) the ability exempt SPVs from the Investment Company Act. Similarly, Regulation AB governs the disclosure requirements for ‘‘asset-backed securities’’ (as such term is defined in Section 1101(c) of Regulation AB) in public offerings. Some have criticized 
73 

102See Mendales, supra note 18. 

103See E. Scott Reckard, ‘‘Sub-Prime mortgage watchdogs kept on leash; loan checkers say 

their warnings of risk were met with indifference,’’ Los Angeles Times, March 17, 2008, at C1. 

Regulation AB for being more permissive than the federal housing agencies with respect to the need to document and verify the loans in a portfolio. 102 Because Regulation AB requires that the issuer not be an investment company (see Item 

101(c)(2)(i) of Regulation AB), its availability (and thus expedited registration) also 

depends on an NRSRO investment grade rating. 

No suggestion is here intended that SPVs should be classified as ‘‘investment companies,’’ but the need for the exemption given by Rule 3a-7 shows that the SEC has 

considerable leverage and could condition this exemption on alternative or additional factors beyond an NRSRO investment grade rating. The key point is that exemptions like Rule 3a-7 give the SEC a tool that they could use even without Congressional legislation—if the SEC was willing to take action. 

What actions should be taken to respond to the deficiencies in asset-backed 

securitizations? I would suggest two basic steps: (1) curtail the ‘‘originate-and-distribute’’ model of lending that gave rise to the moral hazard problem, and (2) reintroduce due diligence into the securities offering process (both for public and Rule 

144A offerings). 

Restricting the ‘‘Originate-and-Distribute’’ Model of Lending. In a bubble, everyone 

expects that they can pass the assets on to the next buyer in the chain—‘‘before the 

music stops.’’ Thus, all tend to economize on due diligence and ignore signs that the 

assets are not creditworthy. This is because none expect to bear the costs of holding 

the financial assets to maturity. 

Things were not always this way. When asset-backed securitizations began, the 

promoter usually issued various tranches of debt to finance its purchase of the mortgage assets, and these tranches differed in terms of seniority and maturity. The promoter would sell the senior most tranche in public offerings to risk averse public 

investors and retain some or all of the subordinated tranche, itself, as a signal of 

its confidence in the creditworthiness of the underlying assets. Over time, this practice of retaining the subordinated tranche withered away. In part, this was because 

hedge funds would take the risk of buying this riskier debt; in part, it was because 

the subordinated tranche could be included in more complex CDOs (where 

overcollateralization was the investor’s principal protection), and finally it was because in a bubbly market, investors no longer looked for commitments or signals 

from the promoter. 

Given this definition of the problem, the answer seems obvious: require the promoter to retain some portion of the subordinated tranche. This would incentivize it 

to buy only creditworthy financial assets and end the ‘‘moral hazard’’ problem. 

To make this proposal truly effective, however, more must be done. The promoter 

would have to be denied the ability to hedge the risk on the subordinated tranche 

that it retained. Otherwise it might hedge that risk by buying a credit default swap 

on its own offering through an intermediary. But this is feasible. Even in the absence of legislation, the SEC could revise Rule 3a-7 to require, as a price of its exemption, that the promoter (either through the SPV or an affiliate) retain a specified percentage of the bottom, subordinated tranche (or, if there were no subordinated tranche, of the offering as a whole). Still, the cleaner, simpler way would be 

a direct legislative requirement of a minimum retention. 

2. Mandating Due Diligence. One of the less noticed but more important developments associated with asset-backed securitization is the rapid decline in due diligence after 2000. Once investment banks did considerable due diligence on assetbacked securitizations, but they outsourced the work to specialized ‘‘due diligence’’ 

firms. These firms (of which Clayton Holdings, Inc. was the best known) would send 

squads of ten to fifteen loan reviewers to sample the loans in a securitized portfolio, 

checking credit scores and documentation. But the intensity of this due diligence review declined over recent years. The Los Angeles Times quotes the CEO of Clayton 

Holdings to the effect that: 

Early in the decade, a securities firm might have asked Clayton to review 

25 percent to 40 percent of the sub-prime loans in a pool, compared with 

typically 10 percent in 2006 103

The President of a leading rival due diligence firm, the Bohan Group, made an 

even more revealing comparison: 
74 

104 Id. 105 Id. 106See President’s Working Group on Financial Markets, Policy Statement on Financial Market Developments at 1 (March, 2008). (emphasis added). This report expressly notes that underwriters had the incentive to perform due diligence, but did not do so adequately. 107See SEC Release No. 7606A (‘‘The Regulation of Securities Offerings’’), 63 Fed. Reg. 67174, 

67230 (Dec. 4 1998). 

By contrast, loan buyers who kept the mortgages as an investment instead 

of packaging them into securities would have 50 percent to 100 percent of 

the loans examined, Bohan President Mark Hughes said. 104

In short, lenders who retained the loans checked the borrowers carefully, but the 

investment banks decreased their investment in due diligence, making only a cursory effort by 2006. Again, this seems the natural consequence of an originate-anddistribute model. 

The actual loan reviewers employed by these firms also told the above-quoted Los 

Angeles Times reporter that supervisors in these firms would often change documentation in order to avoid ‘‘red-flagging mortgages.’’ These employees also report 

regularly encountering inflated documentation and ‘‘liar’s loans,’’ but, even when 

they rejected loans, ‘‘loan buyers often bought the rejected mortgages anyway.’’ 105

In short, even when the watchdog barked, no one at the investment banks truly 

listened. Over the last several years, due diligence practices long followed in the industry seemed to have been relaxed, ignored, or treated as a largely optional formality. That was also the conclusion of the President’s Working Group on Financial 

Markets, which in early 2008 identified ‘‘a significant erosion of market discipline 

by those involved in the securitization process, including originators, underwriters, 

credit rating agencies, and global investors.’’ 106

Still, in the case of the investments bank, this erosion in due diligence may seem 

surprising. At least over the long-term, it seems contrary to their own self-interest. 

Four factors may explain their indifference: (1) an industry-wide decline in due diligence as the result of deregulatory reforms that have induced many underwriters 

to treat legal liability as simply a cost of doing business; (2) heightened conflicts of 

interest attributable to the underwriters’ position as more a principal than an agent 

in structured finance offerings; (3) executive compensation formulas that reward 

short-term performance (coupled with increased lateral mobility in investment banking so that actors have less reason to consider the long-term); and (4) competitive 

pressure. Each is briefly examined below, and then I suggest some proposed reforms 

to address these problems. 

i. The Decline of Due Diligence: A Short History: The Securities Act of 1933 adopted a ‘‘gatekeeper’’ theory of protection, in the belief that by imposing high potential 

liability on underwriters (and others), this would activate them to search for fraud 

and thereby protect investors. As the SEC wrote in 1998: 

Congress recognized that underwriters occupied a unique position that enabled them to discover and compel disclosure of essential facts about the 

offering. Congress believed that subjecting underwriters to the liability provisions would provide the necessary incentive to ensure their careful investigations of the offering.’’ 107

Specifically, Section 11 of the Securities Act of 1933 holds the underwriters (and 

certain other persons) liable for any material misrepresentation or omission in the 

registration statement, without requiring proof of scienter on the part of the underwriter or reliance by the plaintiff. This is a cause of action uniquely tilted in favor 

of the plaintiff, but then Section 11(b) creates a powerful incentive by establishing 

an affirmative defense under which any defendant (other than the issuer) will not 

be held liable if: 

he had, after a reasonable investigation, reasonable ground to believe and 

did believe, at the time such registration statement became effective, that 

the statements made therein were true and that there was an omission to 

state a material fact required to be stated therein or necessary to make the 

statements therein not misleading. 15 U.S.C. § 77k (b)(3)(A). (emphasis 

added) 

Interpreting this provision, the case law has long held that an underwriter must 

‘‘exercise a high degree of care in investigation and independent verification of the 

company’s representations.’’ Feit v. Leasco Data Processing Equip. Corp., 332 F. 

Supp. 554, 582 (E.D.N.Y. 1971). Overall, the Second Circuit has observed that ‘‘no 

greater reliance in our self-regulatory system is placed on any single participant in 
75 

108See Rule 415 (17 C.F.R. § 230.415)(2007). 109See Form S-3, General Instructions, IB5 (‘‘Transaction Requirements—Offerings of Investment Grade Asset-Backed Securities’’). 110 In re WorldCom Inc. Securities Litigation, 346 F. Supp. 2d 628 (S.D.N.Y. 2004). The 

WorldCom decision denied the underwriters’ motion for summary judgment based on their asserted due diligence defense, but never decided whether the defense could be successfully asserted at trial. The case settled before trial for approximately $6.2 billion. 

the issuance of securities than upon the underwriter.’’ Chris-Craft Indus., Inc. v. 

Piper Aircraft Corp., 480 F. 2d 341, 370 (2d Cir. 1973). 

Each underwriter need not personally perform this investigation. It can be delegated to the managing underwriters and to counsel, and, more recently, the task 

has been outsourced to specialized experts, such as the ‘‘due diligence firms.’’ The 

use of these firms was in fact strong evidence of the powerful economic incentive 

that Section 11(b) of the Securities Act created to exercise ‘‘due diligence.’’ 

But what then changed? Two different answers make sense and are complementary: First, many and probably most CDO debt offerings are sold pursuant to Rule 

144A, and Section 11 does not apply to these exempt and unregistered offerings. 

Second, the SEC expedited the processing of registration statements to the point 

that due diligence has become infeasible. The latter development goes back nearly 

thirty years to the advent of ‘‘shelf registration’’ in the early 1980s. In order to expedite the ability of issuers to access the market and capitalize on advantageous market conditions, the SEC permitted issuers to register securities ‘‘for the shelf’’—i.e., 

to permit the securities to be sold from time to time in the future, originally over 

a two year period (but today extended to a three year period). 108 Under this system, 

‘‘takedowns’’—i.e., actual sales under a shelf registration statement—can occur at 

any time without any need to return to the SEC for any further regulatory permission. Effectively, this telescoped a period that was often three or four months in the 

case of the traditional equity underwriting (i.e., the period between the filing of the 

registration statement and its ‘‘effectiveness,’’ while the SEC reviewed the registration statement) to a period that might be a day or two, but could be only a matter 

of hours. 

Today, because there is no longer any delay for SEC review in the case of an 

issuer eligible for shelf registration, an eligible issuer could determine to make an 

offering of debt or equity securities and in fact do so within a day’s time. The original premise of this new approach was that eligible issuers would be ‘‘reporting entities’’ that filed continuous periodic disclosures (known as Form 10-Ks and Form 10- 

Qs) under the Securities Exchange Act of 1934. Underwriters, the SEC hoped, could 

do ‘‘continuing due diligence’’ on these issuers at the time they filed their periodic 

quarterly reports in preparation for a later, eventual public offering. This hope was 

probably never fully realized, but, more importantly, this premise never truly applied to debt offerings by issuers of asset-backed securities. 

For bankruptcy and related reasons, the issuers of asset-backed issuers (such as 

CDOs backed by a pool of residential mortgages) are almost always ‘‘special purpose 

vehicles’’ (SPVs), created for the single offering; they thus have no prior operating 

history and are not ‘‘reporting companies’’ under the Securities Exchange Act of 

1934. To enable issuers of asset-backed securities to use shelf-registration and thus 

obtain immediate access to the capital markets, the SEC had to develop an alternative rationale. And it did! To use Form S-3 (which is a precondition for eligibility 

for shelf-regulation), an issuer of asset-backed securities must receive an ‘‘investment grade’’ rating from an ‘‘NRSRO’’ credit-rating agency. 109 Unfortunately, this 

requirement intensified the pressure that underwriters brought to bear on creditratings agencies, because unless the offering received an investment grade rating 

from at least one rating agency, the offering could not qualify for Form S-3 (and 

so might be delayed for an indefinite period of several months while its registration 

statement received full-scale SEC review). An obvious alternative to the use of an 

NRSRO investment grade rating as a condition for Form S-3 eligibility would be certification by ‘‘gatekeepers’’ to the SEC (i.e., attorneys and due diligence firms) of the 

work they performed. Form S-3 could still require an ‘‘investment grade’’ rating, but 

that it come from an NRSRO rating agency should not be mandatory. 

After 2000, developments in litigation largely convinced underwriters that it was 

infeasible to expect to establish their due diligence defense. The key event was the 

WorldCom decision in 2004. 110 In WorldCom, the court effectively required the 

same degree of investigation for shelf-registered offerings as for traditional offerings, 

despite the compressed time frame and lack of underwriter involvement in the 

drafting of the registration statement. The Court asserted that its reading of the 

rule should not be onerous for underwriters because they could still perform due 

diligence prior to the offering by means of ‘‘continuous due diligence’’ (i.e., through 
76 

111See Donald Langevoort, Deconstructing Section 11: Public Offering Liability in a Continuous Disclosure Environment, 63 Law and Contemporary Problems, U.S. 62-63 (2000). 112See, e.g., Vikas Bajaj and Jenny Anderson, ‘‘Inquiry Focuses on Withholding of Data on 

Loans,’’ New York Times, January 12, 2008, at A-1. 

participation by the underwriter in the drafting of the various Form 10-Ks and 

Form 10-Qs that are incorporated by reference into the shelf-registration). 

For underwriters, the WorldCom decision was largely seen as a disaster. Their 

hopes—probably illusory in retrospect—were dashed that courts would soften Securities Act § 11’s requirements in light of the near impossibility of complying with 

due diligence responsibilities during the shortened time frames imposed by shelf 

registration. Some commentators had long (and properly) observed that the industry 

had essentially played ‘‘ostrich,’’ hoping unrealistically that Rule 176 would protect 

them. 111 In WorldCom’s wake, the SEC did propose some amendments to strengthen Rule 176 that would make it something closer to a safe harbor. But the SEC 

ultimately withdrew and did not adopt this proposal. 

As the industry now found (as of late 2004) that token or formalistic efforts to 

satisfy Section 11 would not work, it faced a bleak choice. It could accept the risk 

of liability on shelf offerings or it could seek to slow them down to engage in full 

scale due diligence. Of course, different law firms and different investment banks 

could respond differently, but I am aware of no firms attempting truly substantial 

due diligence on asset-backed securitizations. Particularly in the case of structured 

finance, the business risk of Section 11 liability seemed acceptable. After all, investment grade bonds did not typically default or result in class action litigation, and 

Section 11 has a short statute of limitations (one year from the date that the plaintiffs are placed on ‘‘inquiry notice’’). Hence, investment banks could rationally decide 

to proceed with structured finance offerings knowing that they would be legally exposed if the debt defaulted, in part because the period of their exposure would be 

brief. In the wake of the WorldCom decision, the dichotomy widened between the 

still extensive due diligence conducted in IPOs, and the minimal due diligence in 

shelf offerings. As discussed below, important business risks may have also motivated investment banks to decide not to slow down structured finance offerings for 

extended due diligence. 

The bottom line here then is that, at least in the case of asset-backed shelf offerings, investment banks ceased to perform the due diligence intended by Congress, 

but instead accepted the risk of liability as a cost of doing business in this context. 

But that is only the beginning of the story. 

Conflicts of Interest: Traditionally, the investment bank in a public offering played 

a gatekeeping role, vetting the company and serving as an agent both for the prospective investors (who are also its clients) and the corporate issuer. Because it had 

clients on both sides of the offering, the underwriter’s relationship with the issuer 

was somewhat adversarial, as its counsel scrutinized and tested the issuer’s draft 

registration statement. But structured finance is different. In these offerings, there 

is no corporate issuer, but only a ‘‘special purpose vehicle’’ (SPV) typically established by the investment bank. The product—residential home mortgages—is purchased by the investment bank from loan originators and may be held in inventory 

by the investment bank for some period until the offering can be effected. In part 

for this reason, the investment bank will logically want to expedite the offering in 

order to minimize the period that it must hold the purchased mortgages in its own 

inventory and at its own risk. 

Whereas in an IPO the underwriter (at least in theory) is acting as a watchdog 

testing the quality of the issuer’s disclosures, the situation is obviously different in 

an assets-backed securities offering that the underwriter is structuring itself. It can 

hardly be its own watchdog. Thus, the quality of disclosure may suffer. Reports have 

circulated that some due diligence firms advised their underwriters that the majority of mortgages loans in some securitized portfolio were ‘‘exception’’ loans—i.e., 

loans outside the bank’s normal guidelines. 112 But the registration statement disclosed only that the portfolio included a ‘‘significant’’ or ‘‘substantial’’ number of 

such loans, not that it was predominantly composed of such loans. This is inferior 

and materially deficient disclosure, and it seems attributable to the built-in conflicts 

in this process. 

Executive Compensation: Investment bankers are typically paid year-end bonuses 

that are a multiple of their salaries. These bonuses are based on successful completion of fee-generating deals during the year. But a deal that generates significant 

income in Year One could eventually generate significant liability in Year Two or 

Three. In this light, the year-end bonus system may result in a short-term focus 

that ignores or overly discounts longer-term risks. 
77 

113See Aaron Lucchetti, ‘‘Big Credit-Rating Firms Agree to Reforms,’’ The Wall Street Journal, June 6, 2008 at p. C-3. 

Moreover, high lateral mobility characterizes investment banking firms, meaning 

that the individual investment banker may not identify with the firm’s longer-term 

interests. In short, investment banks may face serious agency costs problems, which 

may partly explain their willingness to acquire risky mortgage portfolios without 

adequate investigation of the collateral. 

Competitive Pressure: Citigroup CEO Charles Prince’s now famous observation 

that ‘‘when the music is playing, you’ve got to get up and dance’’ is principally a 

recognition of the impact of competitive pressure. If investors are clamoring for ‘‘investment grade’’ CDOs (as they were in 2004–2006), an investment bank understands that if it does not offer a steady supply of transactions, its investors will go 

elsewhere—and possibly not return. Thus, to hold onto a profitable franchise, investment banks sought to maintain a steady pipeline of transactions; this in turn lead 

them to seek to lock in sources of supply. Accordingly, they made clear to loan originators their willingness to buy all the ‘‘product’’ that the latter could supply. Some 

investment banks even sought billion dollar promises from loan originators of a minimum amount of product. Loan originators quickly realized that due diligence was 

now a charade (even if it had not been in the past) because the ‘‘securitizing’’ investment banks were competing fiercely for supply. In a market where the demand 

seemed inexhaustible, the real issue was obtaining supply, and investment banks 

spent little time worrying about due diligence or rejecting a supply that was already 

too scarce for their anticipated needs. 

Providing Time for Due Diligence: The business model for structured finance is 

today broken. Underwriters and credit rating agencies have lost much of their credibility. Until structured finance can regain credibility, housing finance in the United 

States will remain in scarce supply. 

The first lesson to be learned is that underwriters cannot be trusted to perform 

serious due diligence when they are in effect selling their own inventory and are 

under severe time pressure. The second lesson is that because expedited shelf registration is inconsistent with meaningful due diligence, the process of underwriting 

structured finance offerings needs to be slowed down to permit more serious due 

diligence. Shelf registration and abbreviated time schedules may be appropriate for 

seasoned corporate issuers whose periodic filings are incorporated by reference into 

the registration statement, but it makes less sense in the case of a ‘‘special purpose 

vehicle’’ that has been created by the underwriter solely as a vehicle by which to 

sell asset-backed securities. Offerings by seasoned issuers and by special purpose 

entities are very different and need not march to the same drummer (or the same 

timetable). 

An offering process for structured finance that was credible would look very different than the process we have recently observed. First, a key role would be played 

by the due diligence firms, but their reports would not go only to the underwriter 

(who appears to have at time ignored them). Instead, without editing or filtering, 

their reports would also go directly to the credit-rating agency. Indeed, the rating 

agency would specify what it would want to see covered by the due diligence firm’s 

report. Some dialogue between the rating agency and the due diligence firm would 

be built into the process, and ideally their exchange would be outside the presence 

of the underwriter (who would still pay for the due diligence firm’s services). At a 

minimum, the NRSRO rating agencies should require full access to such due diligence reports as a condition of providing a rating (this is a principle with which 

these firms agree, but may find it difficult to enforce in the absence of a binding 

rule). 

To enable serious due diligence to take place, one approach would be to provide 

that structured finance offerings should not qualify for Form S-3 (or for any similar 

form of expedited SEC review). If the process can occur in a day, the pressures on 

all the participants to meet an impossible schedule will ensure that little serious 

investigation of the collateral’s quality will occur. An alternative (or complementary 

approach) would be to direct the SEC to revise Regulation AB to incorporate greater 

verification by the underwriter (and thus its agents) of the quality of the underlying 

financial assets. 

Does this sound unrealistic? Interestingly, the key element in this proposal—that 

that due diligence firm’s report go to the credit rating agency—is an important element in the settlement negotiated in 2008 by New York State Attorney General 

Cuomo and the credit rating agencies. 113

The second element of this proposal—i.e., that the process be slowed to permit 

some dialogue and questioning of the due diligence firm’s findings—will be more 

controversial. It will be argued that delay will place American underwriters at a 
78 

competitive disadvantage to European rivals and that offerings will migrate to Europe. But today, structured finance is moribund on both sides of the Atlantic. To 

revive it, credibility must be restored to the due diligence process. Instantaneous 

due diligence is in the last analysis simply a contradiction in terms. Time and effort 

are necessary if the quality of the collateral is to be verified—and if investors are 

to perceive that a serious effort to protect their interests is occurring. 

Rehabilitating the Gatekeepers 

Credit rating agencies remain the critical gatekeeper whose performance must be 

improved if structured finance through private offerings (i.e., without government 

guarantees) is to become viable again. As already noted, credit rating agencies face 

a concentrated market in which they are vulnerable to pressure from underwriters 

and active competition for the rating business. 

At present, credit rating agencies face little liability and perform little 

verification. Rather, they state explicitly that they are assuming the accuracy of the 

issuer’s representations. The only force that can feasibly induce them to conduct or 

obtain verification is the threat of securities law liability. Although that threat has 

been historically non-existent, it can be legislatively augmented. The credit rating 

agency does make a statement (i.e., its rating) on which the purchasers of debt securities do typically rely. Thus, potential liability does exist under Rule 10b-5 to the 

extent that it makes a statement in connection with a purchase or sale of a security. 

The difficult problem is that a defendant is only liable under Rule 10b-5 if it makes 

a material misrepresentation or omission with scienter. In my judgment, there are 

few cases, if any, in which the rating agencies actually know of the fraud. But, 

under Rule 10b-5, a rating agency can be held liable if it acted ‘‘recklessly.’’ 

Accordingly, I would proposed that Congress expressly define the standard of 

‘‘recklessness’’ that creates liability under Rule 10b-5 for a credit rating agency to 

be the issuance of a rating when the rating agency knowingly or recklessly is aware 

of facts indicating that reasonable efforts have not been conducted to verify the essential facts relied upon by its ratings methodology. A safe harbor could be created 

for circumstances in which the ratings agency receives written certification from a 

‘‘due diligence’’ firm, independent of the promoter, indicating that it has conducted 

sampling procedures that lead it to believe in the accuracy of the facts or estimates 

asserted by the promoter. The goal of this strategy is not to impose massive liabilities on rating agencies, but to make it unavoidable that someone (either the rating 

agency or the due diligence firm) conduct reasonable verification. To be sure, this 

proposal would involve increased costs to conduct such due diligence (which either 

the issuer or the underwriter would be compelled to assume). But these costs are 

several orders of magnitude below the costs that the collapse of the structured finance market has imposed on the American taxpayer. 

Conclusions 

1. The current financial crisis—including the collapse of the U.S. real estate market, the insolvency of the major U.S. investment banks, and the record decline in 

the stock market—was not the product of investor mania or the classic demand-driven bubble, but rather was the product of the excesses of an ‘‘originate-and-distribute’’ business model that both loan originators and investment banks followed 

to the brink of disaster—and beyond. Under this business model, financial institutions abandoned discipline and knowingly made non-creditworthy loans because 

they did not expect to hold the resulting financial assets for long enough to matter. 

2. The ‘‘moral hazard’’ problem that resulted was compounded by deregulatory 

policies at the SEC (and elsewhere) that permitted investment banks to increase 

their leverage rapidly between 2004 and 2006, while also reducing their level of diversification. Under the Consolidated Supervised Entity (CSE) Program, the SEC 

essentially deferred to self-regulation by the five largest investment banks, who 

woefully underestimated their exposure to risk. 

3. This episode shows (if there ever was doubt) that in an environment of intense 

competition and under the pressure of equity-based executive compensation systems 

that are extraordinarily short-term oriented, self-regulation does not work. 

4. As a result, all financial institutions that are ‘‘too big to fail’’ need to be subjected to prudential financial supervision and a common (although risk-adjusted) 

standard. This can only be done by the Federal Reserve Board, which should be 

given authority to regulate the capital adequacy, safety and soundness, and risk 

management practices of all large financial institutions. 

5. Incident to making the Federal Reserve the systemic risk regulator for the U.S. 

economy, it should receive legislative authority to: (1) establish ceilings on debt/equity ratios and otherwise restrict leverage at all major financial institutions (including banks, hedge funds, money market funds, insurance companies, and pension 
79 

1The Securities Industry and Financial Markets Association brings together the shared interests of more than 600 securities firms, banks and asset managers locally and globally through 

offices in New York, Washington, D.C., and London. Its associated firm, the Asia Securities Industry and Financial Markets Association, is based in Hong Kong. SIFMA’s mission is to champion policies and practices that benefit investors and issuers, expand and perfect global capital 

markets, and foster the development of new products and services. Fundamental to achieving 

this mission is earning, inspiring and upholding the public’s trust in the industry and the markets. (More information about SIFMA is available at http://www.sifma.org) 

plans, as well as financial subsidiaries of industrial corporations); (2) supervise and 

restrict the design, and trading of new financial products (particularly including 

over-the-counter derivatives); (3) mandate the use of clearinghouses, to supervise 

them, and in its discretion to require their consolidation; (4) require the writedown 

of risky assets by financial institutions, regardless of whether required by accounting rule; and (5) to prevent liquidate crises by restricting the issuance of short-term 

debt. 

6. Under the ‘‘twin peaks’’ model, the systemic risk regulatory agency would have 

broad powers, but not the power to override the consumer protection and transparency policies of the SEC. Too often bank regulators and banks have engaged in 

a conspiracy of silence to hide problems, lest they alarm investors. For that reason, 

some SEC responsibilities should not be subordinated to the authority of the Federal Reserve. 

7. As a financial technology, asset-backed securitizations have decisively failed. To 

restore credibility to this marketplace, sponsors must abandon their ‘‘originate-anddistribute’’ business model and instead commit to retain a significant portion of the 

most subordinated tranche. Only if the promoter, itself, holds a share of the weakest 

class of debt that it is issuing (and on an unhedged basis) will there be a sufficient 

signal of commitment to restore credibility. 

8. Credit rating agencies must be compelled either to conduct reasonable 

verification of the key facts that they are assuming in their ratings methodology or 

to obtain such verification from professionals independent of the issuer. For this obligation to be meaningful, it must be backstopped by a standard of liability specifically designed to apply to credit-rating agencies. 

PREPARED STATEMENT OF T. TIMOTHY RYAN, JR. 

PRESIDENT AND CHIEF EXECUTIVE OFFICER, 

SECURITIES INDUSTRY AND FINANCIAL MARKETS ASSOCIATION

MARCH 10, 2009 

Chairman Dodd, Ranking Member Shelby, Members of the Committee; My name 

is Tim Ryan and I am President and CEO of the Securities Industry and Financial 

Markets Association (SIFMA). 1 Thank you for your invitation to testify at this important hearing. The purpose of my testimony is to share SIFMA’s views on how 

we might improve investor protection as well as the regulation of our financial markets. 

Overview 

Our current financial crisis, which has affected nearly every American family, underscores the imperative to modernize our financial regulatory system. Our regulatory structure and the plethora of regulations applicable to financial institutions 

are based on historical distinctions among banks, securities firms, insurance companies, and other financial institutions—distinctions that no longer conform to the way 

business is conducted. Today, financial services institutions perform many similar 

activities without regard to their legacy charters, and often provide investors with 

similar products and services, yet may be subject to different rules and to the authority of different regulatory agencies because of the functions performed in a bygone era. 

Regulators continue to operate under authorities largely established many decades ago. They also often operate without sufficient coordination and cooperation 

and without a complete picture of the market as a whole. For example, the Securities and Exchange Commission (SEC) oversees brokerdealer activity. Futures firms 

are regulated by the Commodity Futures Trading Commission (CFTC), while the insurance industry is regulated by 50 State insurance regulators. Thrifts are regulated by the Office of Thrift Supervision, and banks may be overseen at the Federal 

level by the Office of the Comptroller of the Currency, the Federal Reserve Board, 

or the Federal Deposit Insurance Corporation. At the same time, some financial institutions, such as hedge funds, largely escape regulation altogether. 
80 

As a result, our current regulatory framework is characterized by duplicative or 

inconsistent regulation, and in some instances insufficient or insufficiently coordinated oversight. The negative consequences to the investing public of this patchwork 

of regulatory oversight are real and pervasive. Investors do not have comparable 

protections across the same or similar financial products. Rather, the disclosures, 

standards of care and other key investor protections vary based on the legal status 

of the intermediary or the product or service being offered. For example, similar financial advisory services may be delivered to retail clients via a broker-dealer, an 

investment adviser, an insurance agent, or a trustee, thereby subjecting similar advisory activities to widely disparate regulatory requirements. From the perspective 

of financial institutions, many are subject to duplicative, costly, and unnecessary 

regulatory burdens, including multiple rulebooks, and multiple examinations and 

enforcement actions for the same activity, that provide questionable benefits to investors and the markets as a whole. 

This regulatory hodgepodge unnecessarily exposes investors, market participants, 

and regulators alike to the potential risk of under-regulation, overregulation, or inconsistent regulation, both within the U.S. and globally. A complex and overlapping 

regulatory structure results in higher costs on all investors, depriving them of investment opportunities. Simply enhancing regulatory cooperation among the many 

different regulators will not be sufficient to address these issues. 

In light of these concerns, SIFMA advocates simplifying and reforming the financial regulatory structure to maximize and enhance investor protection and market 

integrity and efficiency. More specifically, we believe that a reformed—and sound— 

regulatory structure should accomplish the following goals: First, it must minimize 

systemic risk. Second, through a combination of structural and substantive reforms, 

it must be as effective and efficient as possible, while at the same time promoting 

and enhancing fair dealing and investor protection. Finally, it should encourage consistent regulation across the same or similar businesses and products, from country 

to country, to minimize regulatory arbitrage. 

Creation of a Financial Markets Stability Regulator 

Systemic risk has been at the heart of the current financial crisis. While there 

is no single, commonly accepted definition of systemic risk, we think of ‘‘systemic 

risk’’ as the risk of a system wide financial crisis characterized by a significant risk 

of the contemporaneous failure of a substantial number of financial institutions or 

of financial institutions or a financial market controlling a significant amount of financial resources that could result in a severe contraction of credit in the U.S. or 

have other serious adverse effects on economic conditions or financial stability. 

SIFMA has devoted considerable time and resources to thinking about systemic risk, 

and what can be done to identify it, minimize it, maintain financial stability and 

resolve a financial crisis in the future. A regulatory reform committee of our members has met regularly in recent months to consider these issues and to develop a 

workable proposal to address them. We have sponsored roundtable discussions with 

former regulators, financial services regulatory lawyers and our members, as well 

as other experts, policymakers, and stakeholders to develop solutions to the issues 

that have been exposed by the financial crisis and the challenges facing our financial markets and, ultimately and most importantly, America’s investors. 

Through this process, we have identified a number of questions and tradeoffs that 

will confront policymakers in trying to mitigate systemic risk. Although our members continue to consider this issue, there seems to be consensus that we need a 

financial markets stability regulator as a first step in addressing the challenges facing our overall financial regulatory structure. The G30, in its report on financial reform, supports a central body with the task of promoting and maintaining financial 

stability, and the Treasury, in its blueprint, also has supported a market stability 

regulator. 

We are realistic in what we believe a financial markets stability regulator can accomplish. It will not be able to identify the causes or prevent the occurrence of all 

financial crises in the future. But at present, no single regulator (or collection of coordinated regulators) has the authority or the resources to collect information system-wide or to use that information to take corrective action in a timely manner 

across all financial institutions and markets regardless of charter. We believe that 

a single, accountable financial markets stability regulator will improve upon the 

current system. 

While our position on the mission of the financial markets stability regulator is 

still evolving, we currently believe that its mission should consist of mitigating systemic risk, maintaining financial stability and addressing any financial crisis, all of 

which will benefit the investing public. It should have authority over all markets 

and market participants, regardless of charter, functional regulator or unregulated 
81 

2See Ben S. Bernanke, Federal Reserve Board Chairman, Remarks at the Federal Reserve 

Bankof Atlanta’s 2007 Financial Markets Conference, Sea Island, Georgia (May 15, 2007), at 

http://www.federalreserve.gov/boarddocs/Speeches/2007/20070515/default.htm 3 Investor and Industry Perspectives on Investment Advisers and Broker-Dealers, RAND 

Institutefor Civil Justice, December 31, 2007, available at http://www.sec.gov/news/press/ 

2008/2008-1lrandiabdreport.pdf 

status. In carrying out its duties, the financial markets stability regulator should 

coordinate with the relevant functional regulators, as well as the President’s Working Group, as applicable, in order to avoid duplicative or conflicting regulation and 

supervision. It should also coordinate with regulators responsible for systemic risk 

in other countries. It should have the authority to gather information from all financial institutions and markets, adopt uniform regulations related to systemic risk, 

and act as a lender of last resort. It should probably have a more direct role in supervising systemically important financial organizations, including the power to conduct examinations, take prompt corrective action and appoint or act as the receiver 

or conservator of all or part of a systemically important organization. These more 

direct powers would end if a financial group were no longer systemically important. 

Other Reforms That Would Enhance Investor Protection and Improve Market Efficiency 

While we believe that a financial markets stability regulator will contribute to enhancing investor protection and improving market efficiency, we also believe, as a 

second step, that we must work to rationalize the broader financial regulatory 

framework to eliminate regulatory gaps and imbalances that contribute to systemic 

risk. Specifically, SIFMA believes that more effective and efficient regulation of financial institutions—resulting in greater investor Protection—is likely to be 

achieved by regulating similar activities and firms in a similar manner and by consolidating certain financial regulators. 

Core Standards Governing Business Conduct 

Currently, the regulation of the financial industry is based predominantly on 

rules that were first established during the 1930s and 1940s, when the products and 

services offered by banks, broker-dealers, investment advisors and insurance companies were distinctly different. Today, however, the lines and distinctions among 

these companies and the products and services they offer have become largely 

blurred. Development of a single set of standards governing business conduct of financial institutions towards individual and institutional investors, regardless of the 

type of industry participant or the particular products or services being offered, 

would promote and enhance investor protection, and reduce potential regulatory arbitrage and inefficiencies that are inherent in the existing system of multiple regulators and multiple, overlapping rulebooks. 

The core standards should be crafted so as to be flexible enough to adapt to new 

products and services as well as evolving market conditions, while providing sufficient direction for firms to establish enhanced compliance systems. As Federal Reserve Board Chairman Ben Bernanke once suggested, ‘‘a consistent, principlesbased, and risk-focused approach that takes account of the benefits as well as the 

risks that accompany financial innovation’’ is an effective way toprotect investors 

while maintaining the integrity of the marketplace. 2

This core standards approach, however, must be accompanied by outcome-oriented 

rules (where rules are necessary), an open dialogue between the regulator and regulated, and enforcement efforts focused on addressing misconduct and fraud and protecting the investing public. 

Harmonize Investment Advisor and Broker-Dealer Regulation 

SIFMA has long advocated the modernization and harmonization of the disparate 

regulatory regimes for investment advisory, brokerage and other financial services 

in order to promote investor protection. A 2007 RAND Corporation report commissioned by the SEC found that efforts to describe a financial service provider’s duties 

or standard of care in legalistic terms, such as ‘‘fiduciary duty’’ or ‘‘suitability,’’ contributes to—rather than resolves—investor confusion. 3 Further complicating matters, the laws that apply to many customer accounts, such as ERISA (for employersponsored retirement plans) or the Internal Revenue Code (for IRAs), have different 

definitions of fiduciaries, and prohibitions on conduct and the sale of products that 

differ from those under the Investment Advisers Act and state law fiduciary concepts. The RAND report makes clear that individual investors generally do not understand, appreciate, or care about such legal distinctions. 

Rather than perpetuating an obsolete regulatory regime, SIFMA recommends the 

adoption of a ‘‘universal standard of care’’ that avoids the use of labels that tend 
82 

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. It would make clear to individual investors 

that their financial professionals are obligated to treat them fairly by employing the 

same core standards whether the firm is a financial planner, an investment adviser, 

a securities broker-dealer, a bank, an insurance agency or another type of financial 

services provider. A universal standard would not limit the ability of individual investors to contract for and receive a broad range of services from their financial 

services providers, from pure execution of customer orders to discretionary investment advice, nor would it limit the ability of clients to define or modify relationships 

with their financial services providers in ways they so choose. 

As Congress contemplates regulatory reform, particularly in the wake of the 

Madoff and Stanford scandals and the recent turbulence in our financial markets, 

we believe that the time has come to focus on the adoption of a universal investor 

standard of care. 

In addition, we urge Congress to pursue a regulatory framework for financial 

services providers that is understandable, practical and provides flexibility sufficient 

for these intermediaries to provide investors with both existing and future products 

and services. Such a framework must also avoid artificial or vague distinctions (such 

as those based on whether any investment advice is ‘‘solely incidental’’ to brokerage 

or whether any compensation to the financial services provider is ‘‘special’’). Finally, 

the framework should support investor choice through appropriate relief from the 

SEC’s rigid prohibitions against principal trading, particularly with respect to products traded in liquid and transparent markets, which has had the effect of foreclosing investors from obtaining more favorable pricing on transactions based on the 

requirement for transaction-by-transaction consent. 

Broaden the Authority of the MSRB 

The Municipal Securities Rulemaking Board (MSRB) regulates the conduct of only 

broker-dealers in the municipal securities market. We feel it is important to level 

the regulatory playing field by increasing the MSRB’s authority to encompass the 

regulation of financial advisors, investment brokers and other intermediaries in the 

municipal market to create a comprehensive regulatory framework that prohibits 

fraudulent and manipulative practices; requires fair treatment of investors, state 

and local government issuers of municipal bonds and other market participants; ensures rigorous standards of professional qualifications; and promotes market efficiencies. 

Merge the SEC and CFTC 

The United States is the only jurisdiction that splits the oversight of securities 

and futures activities between two separate regulatory bodies. When the CFTC was 

formed, financial futures represented a very small percentage of futures activity. 

Now, an overwhelming majority of futures that trade today are financial futures. 

These products are nearly identical to SEC regulated securities options from an economic standpoint, yet they are regulated by the CFTC under a very different regulatory regime. This disparate regulatory treatment detracts from the goal of investor 

protection. An entity that combines the functions of both agencies could be better 

positioned to apply consistent rules to securities and futures. 

OTC Derivatives 

Although OTC derivatives transactions generally are limited to institutional participants, the use of OTC derivatives by American businesses to manage risks and 

reduce funding costs provides important benefits for our economy and, consequently, 

for individual investors as well. At the same time, problems with OTC derivatives 

can adversely affect the financial system and individual investors. Accordingly, we 

believe that steps should be taken to further develop the infrastructure that supports the OTC derivatives business and to improve the regulatory oversight of that 

activity. 

In particular, we strongly support our members’ initiative to establish a clearinghouse for credit default swaps (CDS) and we are pleased to note that ICE US Trust 

LLC opened its doors for clearing CDS transactions yesterday. We believe that development of a clearinghouse for credit derivatives is an effective way to reduce 

counterparty credit risk and, thus, promote market stability. In addition to reducing 

risk, the clearinghouse will facilitate regulatory oversight by providing a single access point for information about the CDS transactions it processes. 

We also believe that all systemically significant participants in OTC derivatives 

markets should be subject to oversight by a single systemic regulator. (It is noteworthy that the AIG affiliate that was an active participant in the CDS market was 
83 

not subject to meaningful regulatory supervision.) The systemic regulator should be 

given broad authority to promulgate rules and regulations to promote sound practices and reduce systemic risk. We recognize that effective regulation requires timely access to relevant information and we believe the systemic regulator should have 

the necessary authority to assure there is appropriate regulatory transparency. 

Investor Protection Through International Cooperation and Coordination 

Finally, the current financial crisis reminds us that markets are global in nature 

and so are the risks of contagion. To promote investor protection through effective 

regulation and the elimination of disparate regulatory treatment, we believe that 

common regulatory standards should be applied consistently across markets. Accordingly, we urge that steps be taken to foster greater cooperation and coordination 

among regulators in major markets in the U.S., Europe, Asia, and elsewhere around 

the world. There are several international groups in which the U.S. participates 

that work to further regulatory cooperation and establish international standards, 

including IOSCO, the Joint Forum, the Basel Committee on Banking Supervision, 

and the Financial Stability Forum. Congress should support and encourage the efforts of these groups. 

Conclusion 

Recent challenges have highlighted the necessity of reforms to enhance investor 

protection. SIFMA strongly supports these efforts and commits to be a constructive 

participant in the process. SIFMA stands ready to assist the Committee as it considers regulatory reform to minimize systemic risk, promote consistent and efficient 

regulation, eliminate regulatory arbitrage, and promote capital formation—all of 

which serve, directly or indirectly, the interest of investor protection. We are confident that through our collective efforts, we have the capacity to emerge from this 

crisis with stronger and more modern regulatory oversight that will not only prepare us for the challenges facing financial firms today and in the future, but also 

help the investing public meet its financial needs and support renewed economic 

growth and job creation. 

PREPARED STATEMENT OF PAUL SCHOTT STEVENS 

PRESIDENT AND CHIEF EXECUTIVE OFFICER, 

INVESTMENT COMPANY INSTITUTE

MARCH 10, 2009 

Executive Summary 

Overview: Recommendations for Financial Services Regulatory Reform 

• The current financial crisis provides policymakers with the public mandate 

needed to take bold steps to strengthen and modernize our financial regulatory 

system. It is imperative to registered investment companies (also referred to as 

‘‘funds’’), as both issuers of securities to investors and purchasers of securities 

in the market, that the regulatory system ensure strong investor protection and 

foster competition and efficiency in the capital markets. The ultimate outcome 

of reform efforts will have a direct and lasting effect on the fund industry and 

the millions of investors who choose funds to help them save for the future. 

• As detailed in a recently released white paper (attached as Appendix A), ICI 

recommends: (1) establishing a Systemic Risk Regulator; (2) creating a Capital 

Markets Regulator representing the combined functions of the Securities and 

Exchange Commission and the Commodity Futures Trading Commission; (3) 

considering consolidation of the bank regulatory structure and authorization of 

an optional federal charter for insurance companies; and (4) enhancing coordination and information sharing among federal financial regulators. 

• If enacted, these reforms would improve regulators’ capability to monitor and 

mitigate risks across the financial system, enhance regulatory efficiency, limit 

duplication, close regulatory gaps, and emphasize the national character of the 

financial services industry. 

Systemic Risk Regulator 

• The Systemic Risk Regulator should have responsibility for: (1) monitoring the 

financial markets broadly; (2) analyzing changing conditions in domestic and 

overseas markets; (3) evaluating the risks of practices as they evolve and identifying those that are of such nature and extent that they implicate the health 

of the financial system at large; and (4) acting in coordination with other responsible regulators to mitigate such risks. 
84 

• Careful consideration should be given to how the Systemic Risk Regulator will 

be authorized to perform its functions and its relationship with other, specialized regulators. 

Capital Markets Regulator 

• The Capital Markets Regulator should have oversight responsibility for the capital markets, market participants, and all financial investment products. It 

should be the regulatory standard setter for funds, including money market 

funds. 

• The agency’s mission should focus on investor protection and law enforcement, 

as well as maintaining the integrity of the capital markets. Like the SEC, it 

should be required to consider whether proposed regulations protect investors 

and promote efficiency, competition, and capital formation. 

• The Capital Markets Regulator should be an independent agency, with the resources to fulfill its mission and the ability to attract experienced personnel who 

can fully grasp the complexities of today’s markets. ICI’s white paper offers recommendations for organizing and managing the new agency and for how the 

agency can maximize its effectiveness. 

Selected Other Areas for Reform 

• The Capital Markets Regulator should have express authority to regulate in 

areas where there are currently gaps that have the potential to impact the capital markets and market participants, and to modernize regulation that has not 

kept pace with changes in the marketplace. These areas include: (1) hedge 

funds; (2) derivatives; (3) municipal securities; and (4) the regulation of investment advisers and broker-dealers. 

Recent Market Events and Money Market Funds 

• Money market funds, stringently regulated by the SEC, are one of the most notable product innovations in American history. These funds—which seek to offer 

investors stability of principal, liquidity, and a market-based rate of return, all 

at a reasonable cost—serve as an effective cash management tool for retail and 

institutional investors, and are an exceptionally important source of short-term 

financing in the U.S. economy. 

• Until September 2008, money market funds, in some cases with support from 

their sponsors, largely weathered severe pressures in the fixed income markets 

that had been striking banks and other financial services firms since 2007. In 

mid-September, a series of extraordinary developments, including the failure of 

Lehman Brothers, roiled financial markets around the globe, affecting all market participants. In the midst of this market storm, one money market fund 

holding a substantial amount of Lehman commercial paper was unable to sustain its $1.00 price per share. The news of this fund ‘‘breaking the buck,’’ combined with broader concerns about the building stresses in the money market 

and possible failures of other financial institutions, led to heavy redemptions in 

prime money market funds as investors sought safety and liquidity in Treasury 

securities. 

• Unprecedented government initiatives—designed to provide stability and liquidity to the markets and to support money market funds—successfully bolstered 

investor confidence. To date, the Treasury Temporary Guarantee Program for 

Money Market Funds has received no claims for its guarantee, and none are 

anticipated. Assuming continued progress in restoring the health of the money 

market, there will be no need to extend the Temporary Guarantee Program beyond its current one-year maximum period. 

• To capture the lessons learned from recent experience, ICI formed a Money 

Market Working Group of senior fund industry leaders, led by John J. Brennan 

of The Vanguard Group. The Working Group has conducted a thorough examination of how the money market can function better, and how all funds operating in that market, including registered money market funds, should be regulated. The Working Group intends to report its findings, conclusions, and recommendations later this month. We believe that prompt implementation of its 

recommendations will help assure a smooth transition away from the Temporary Guarantee Program. 

Introduction 

My name is Paul Schott Stevens. I am President and CEO of the Investment 

CompanyInstitute, the national association of U.S. investment companies, including 

mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment 

trusts (UITs). Members of ICI manage total assets of $9.88 trillion and serve over 
85 

1See Investment Company Institute, Financial Services Regulatory Reform: Discussion and 

Recommendations (March 3, 2009), available at http://www.ici.org/pdf/ 

pprl09lreglreform.pdf and attached as Appendix A. 

93 million shareholders. ICI is pleased to testify today about investor protection and 

the regulation of securities markets. 

This hearing takes place at a time when the United States and a host of other 

nations are grappling with the most significant financial crisis in generations. In 

this country, the crisis has revealed significant weaknesses in our current system 

for oversight of financial institutions. At the same time, it offers an important opportunity for robust dialogue about the way forward. And it provides policymakers 

with the public mandate needed to take bold steps to strengthen and modernize regulatory oversight of the financial services industry. We strongly commend this Committee for the substantial attention it is devoting to examining the causes of the 

current crisis and considering how the regulatory system can best be improved, with 

particular focus on protecting consumers and investors. 

It is no exaggeration that the ultimate outcome of these reform efforts will have 

a direct and lasting impact on the future of our industry. By extension, the decisions 

you make will affect the millions of American investors who choose registered investment companies (also referred to as ‘‘funds’’) as investment vehicles to help 

them meet the costs of college, their retirement needs, or other financial goals. 

Funds themselves are among the largest investors in U.S. companies, holding about 

one quarter of those companies’ outstanding stock. Funds also hold approximately 

40 percent of U.S. commercial paper, an important source of short-term funding for 

corporate America, and more than one third of tax-exempt debt issued by U.S. municipalities. It is thus imperative to funds, as both issuers of securities to investors 

and purchasers of securities in the market, that our financial regulatory system ensure strong protections for investors and foster competition and efficiency within the 

capital markets. 

Like other stakeholders, we have been thinking very hard about how to revamp 

our current system so that our nation emerges from this crisis with stronger, wellregulated institutions operating within a fair, efficient, and transparent marketplace. Last week, ICI released a white paper outlining detailed recommendations on 

how to reform the U.S. financial regulatory system, with particular emphasis on reforms most directly affecting the functioning of the capital markets and the regulation of investment companies. 1 Section II of my testimony provides a summary of 

these recommendations. 

In addition to demonstrating the need to reform our financial regulatory system, 

events of the past year have highlighted the need for greater protections for both 

investors and the marketplace in several specific areas. Section III of my testimony 

outlines ICI’s recommendations for legislative authority to address certain regulatory gaps that have the potential to affect the capital markets and market participants, and to modernize regulation that has not kept pace with changes in the marketplace. 

Finally, as discussed in Section IV of my testimony, events of the past year have 

brought into sharp focus the significance of money market funds and the critical role 

they play as a low-cost funding vehicle for the American economy. While the regulatory regime for money market funds has proven to be flexible and resilient, lessons learned from recent events suggested the need for a thorough examination of 

how the money market can function better and how all funds operating in that market should be regulated. To that end, ICI last November formed a working group 

of senior fund industry leaders with a broad mandate to develop recommendations 

in these areas. The Money Market Working Group is chaired by John J. Brennan, 

Chairman of The Vanguard Group, and expects to issue a detailed report by the end 

of March. We would welcome the opportunity to discuss with this Committee the 

recommendations of the Money Market Working Group following the release of its 

report. 

Financial Services Regulatory Reform 

Overview of ICI Recommendations 

Broadly speaking, ICI recommends changes to our regulatory structure that would 

create a framework to enhance regulatory efficiency, limit duplication, close regulatory gaps, and emphasize the national character of the financial services industry. 

To improve the government’s capability to monitor and mitigate risks across the financial system, ICI supports the designation of a new or existing agency or interagency body as a ‘‘Systemic Risk Regulator.’’ A new ‘‘Capital Markets Regulator’’ 

should encompass the combined functions of the Securities and Exchange Commis-
86 

sion and the Commodity Futures Trading Commission, thus creating a single independent federal regulator responsible for oversight of U.S. capital markets, market 

participants, and all financial investment products. ICI further recommends that 

Congress consider consolidating the regulatory structure for the banking sector and 

authorizing an optional federal charter for insurance companies. Such a regulatory 

framework—with one or more dedicated regulators to oversee each major financial 

services sector—would maintain specialized regulatory focus and expertise, as well 

as avoid the potential for one industry sector to take precedence over the others in 

terms of regulatory priorities or the allocation of resources. 

To ensure the success of this new financial regulatory structure, there must be 

effectivecoordination and information sharing among the financial regulators, including in particular the Systemic Risk Regulator. Stronger links among these regulators should greatly assist in developing sound policies and should facilitate U.S. 

cooperation with the international regulatory community. In our white paper, we 

discuss why the President’s Working Group on Financial Markets, with certain 

modifications, may be the most logical mechanism through which to accomplish 

these purposes. 

Systemic Risk Regulator 

The current financial crisis has exposed the vulnerability of our financial system 

to risks that have the potential to spread rapidly throughout the system and cause 

significant damage. Analyses of the causes of the current crisis suggest that systemic risks may be occasioned by, for example, excessive leveraging, lack of transparency regarding risky practices, and gaps in the regulatory framework. 

ICI agrees with the growing consensus that our regulatory system needs to be better equipped to anticipate and address systemic risks affecting the financial markets. Some have called for the establishment of a ‘‘Systemic Risk Regulator.’’ Subject 

to important cautions, ICI supports designating a new or existing agency or interagency body to serve in this role. We recommend that the Systemic Risk Regulator 

have responsibility for: (1) monitoring the financial markets broadly; (2) analyzing 

changing conditions in domestic and overseas markets; (3) evaluating the risks of 

practices as they evolve and identifying those that are of such nature and extent 

that they implicate the health of the financial system at large; and (4) acting in coordination with other responsible regulators to mitigate such risks. 

The specifics of creating and empowering the Systemic Risk Regulator will require 

careful attention. By way of example, to perform its monitoring functions, this regulator likely will need information about a range of financial institutions and market 

sectors. The types of information that the regulator may require, and how the regulator will obtain that information, are just two of the discrete issues that will need 

to be fully considered. 

In ICI’s view, legislation establishing the Systemic Risk Regulator should be crafted to avoid imposing undue constraints or inapposite forms of regulation on normally functioning elements of the financial system, or stifling innovations, competition, or efficiencies. For example, it has been suggested that a Systemic Risk Regulator could be given the authority to identify financial institutions that are ‘‘systemically significant’’ and to oversee those institutions directly. Despite its seeming appeal, such an approach could have very serious anticompetitive effects if the identified institutions were viewed as ‘‘too big to fail’’ and thus judged by the marketplace 

as safer bets than their smaller, ‘‘less significant’’ competitors. 

Additionally, the Systemic Risk Regulator should be carefully structured so as not 

to simply add another layer of bureaucracy or to displace the primary regulators responsible for capital markets, banking, or insurance. Legislation establishing the 

Systemic Risk Regulator thus should define the nature of the relationship between 

this new regulator and the primary regulators for these industry sectors. The authority granted to the Systemic Risk Regulator should be subject to explicit limitations, and the specific areas in which the Systemic Risk Regulator and the primary 

regulators should work together will need to be identified. We believe, for example, 

that the primary regulators have a critical role to play as the first line of defense 

for detecting potential risks within their spheres of expertise. 

Capital Markets Regulator 

Currently, securities and futures—and their respective markets and market participants—are subject to separate regulatory regimes under different federal regulators. This system reflects historical circumstances and is out of step with the increasing convergence of these two industries. It has resulted in jurisdictional disputes, regulatory inefficiency, and gaps in investor protection. To bring a consistent 

policy focus to U.S. capital markets, ICI recommends the creation of a Capital Markets Regulator as a new agency that would encompass the combined functions of 
87 

2From the perspective of funds as investors in corporate and fixed income securities, ICI believes that financial reporting that requires the use of mark-to-market or fair value accounting 

to measure the value of financial instruments serves the interests of investors and the capital 

markets better than alternative cost-based measures. For a more detailed discussion of our 

views, see Letter from Paul Schott Stevens, President and CEO, Investment Company Institute, 

to The Honorable Christopher Cox, Chairman, U.S. Securities and Exchange Commission, dated 

November 14, 2008, available at http://www.ici.org/statements/cmltr/08lseclmark-to-marketlcom.html 

the SEC and the CFTC. As the federal regulator responsible for overseeing the capital markets and all financial investment products, the Capital Markets Regulator— 

like the SEC and the CFTC—should be established as an independent agency, with 

an express statutory mission and the rulemaking and enforcement powers necessary 

to carry out that mission. 

It is critically important that the Capital Markets Regulator’s statutory mission 

focus theagency sharply on investor protection and law enforcement, as distinct 

from the safety and soundness of regulated entities. At the same time, the Capital 

Markets Regulator (like the SEC today) should be required to consider, in determining whether a proposed regulation is consistent with the public interest, both 

the protection of investors and whether the regulation would promote efficiency, 

competition, and capital formation. The Capital Markets Regulator’s mission also 

should include maintaining the integrity of the capital markets, which will benefit 

both market participants and consumers. Congress should ensure that the agency 

is given the resources it needs to fulfill its mission. Most notably, the Capital Markets Regulator must have the ability to attract personnel with the necessary market 

experience to fully grasp the complexities of today’s global marketplace. 

ICI envisions the Capital Markets Regulator as the regulatory standard setter for 

registered investment companies, including money market funds (as is the case now 

with the SEC). In so authorizing this new agency, Congress would be continuing the 

important benefits that have flowed from the shared system of federal and state 

oversight established by the National Securities Markets Improvement Act of 1996. 

Under this system, federal law governs all substantive regulation of investment 

companies, and states have concurrent authority to protect against fraud. We believe that this approach is consistent with the national character of the market in 

which investment companies operate and would continue to achieve the regulatory 

efficiencies Congress intended, without compromising investor protection in any 

way. 

The Capital Markets Regulator should continue to regulate registered investment 

companies under the Investment Company Act of 1940. While funds are not immune 

to problems, the substantive protections embodied in the Investment Company Act 

and related rules have contributed significantly to the protection of investors and 

the continuing integrity of funds as an investment model. Among these protections 

are: (1) daily pricing and redeemability of the fund’s shares, with a requirement to 

use mark-to-market valuation; (2) separate custody of fund assets (typically with a 

bank custodian); (3) restrictions on complex capital structures and leveraging; (4) 

prohibitions or restrictions on affiliated transactions and other forms of self-dealing; 

and (5) diversification requirements. In addition, funds are subject to more extensive 

disclosure and transparency requirements than any other financial product. This 

regulatory framework has proven resilient through difficult market conditions, and 

has shielded fund investors from some of the problems associated with other financial products and services. Indeed, recent experience suggests that consideration 

should be given to extending the greater discipline that has worked so well in core 

areas of fund regulation—such as valuation, 2 independent custody, affiliated transaction prohibitions, leveraging restrictions, diversification, and transparency—to 

other marketplace participants. 

With the establishment of a new Capital Markets Regulator, Congress has a very 

valuable opportunity to ‘‘get it right’’ in terms of how the new agency is organized 

and managed. Our white paper outlines several recommendations in this regard, including the need for high-level focus on management of the agency. We stress the 

importance, for example, of the agency’s having open and effective lines of internal 

communication, mechanisms to facilitate internal coordination and information 

sharing, and a comprehensive process for setting regulatory priorities and assessing 

progress. 

ICI’s white paper also suggests ways in which the Capital Markets Regulator 

would be able to maximize its effectiveness in performing its responsibilities. I 

would like to highlight two of the most significant suggestions for the Committee. 

First, the Capital Markets Regulator should seek to facilitate close, cooperative 

interaction with the entities it regulates as a means to identify and resolve prob-
88 

lems, to determine the impact of problems or practices on investors and the market, 

and to cooperatively develop best practices that can be shared broadly with market 

participants. Incorporating a more preventative approach would likely encourage 

firms to step forward with self-identified problems and proposed resolutions. Second, 

the Capital Markets Regulator should establish mechanisms to stay abreast of market and industry developments. Ways to achieve this end include hiring more agency staff with significant prior industry experience and establishing by statute a multidisciplinary ‘‘Capital Markets Advisory Committee’’ comprised of private-sector 

representatives from all major sectors of the capital markets. 

Expected Benefits of These Reforms 

If implemented, the recommended reforms outlined above and discussed in detail 

in our white paper would help to establish a more effective and efficient regulatory 

structure for the U.S. financial services industry. Most significantly, these reforms 

would: 

• Improve the U.S. government’s capability to monitor and mitigate risks across 

our nation’s financial system; 

• Create a regulatory framework that enhances regulatory efficiency, limits duplication, and emphasizes the national character of the financial services industry; 

• Close regulatory gaps to ensure appropriate oversight of all market participants 

and investment products; 

• Preserve specialized regulatory focus and expertise while avoiding the potential 

for uneven attention to different industries or products; 

• Foster a culture of close consultation and dialogue among U.S. financial regulators to facilitate collaboration on issues of common concern; and 

• Facilitate coordinated interaction with regulators in other jurisdictions, including with regard to risks affecting global capital markets. 

We recognize that some have criticized sector-based regulation because it may not 

provide any one regulator with a full view of a financial institution’s overall business, and does not give any single regulator authority to mandate actions designed 

to mitigate systemic risks across financial markets as a whole. Our proposed approach would address those concerns through the establishment of the Systemic 

Risk Regulator to undertake this market-wide monitoring of the financial system 

and through specific measures to strengthen inter-agency coordination and information sharing. 

We further believe that retaining some elements of the current multi-agency 

structure would offer advantages over a single, integrated regulator approach. Even 

though a single regulator could be organized with separate units or departments focusing on different financial services sectors, it is our understanding that, in practice, there can be a tendency for agency leadership or staff to gravitate to certain 

areas and devote insufficient attention to financial sectors perceived to be less high 

profile or prone to fewer problems. Such a result has the potential to stifle innovation valuable to consumers and produce regulatory disparities. 

Finally, we believe that a streamlining of the current regulatory structure may 

be more effective and workable than an approach that assigns regulatory responsibilities to separate agencies based on broad regulatory objectives, such as market 

stability, safety and soundness, and business conduct. These functions often are 

highly interrelated. Not only could separating them prove quite challenging, but it 

would force regulators to view institutions in a less integrated way and to operate 

with a narrower, less informed knowledge base. For example, a Capital Markets 

Regulator is likely to be more effective in protecting investors if its responsibilities 

require it to maintain a thorough understanding of capital market operations and 

market participants. And while an objective-based structure could be one way to 

promote consistent regulation of similar financial products and services, it is not the 

only way. Under our proposed approach, minimizing regulatory disparities for like 

products and services would be an express purpose of enhanced inter-agency coordination and information sharing efforts. 

Selected Other Areas for Reform 

Recent experiences in the markets have underscored the need for the Capital 

Markets Regulator (or, until Congress creates such a new agency, the SEC) to have 

express authority to regulate in certain areas where there are currently gaps that 

have the potential to impact the capital markets and market participants, and to 
89 

3 Although not necessitating legislative action, another area for reform is regulation of credit 

rating agencies. ICI has long supported increased regulatory oversight, disclosure, and transparency requirements for credit rating agencies. We strongly support recent regulatory initiatives that will impose additional disclosure, reporting, and recordkeeping requirements on a nationally recognized statistical ratings organization (NRSRO) for products that it rates. These requirements, which are intended to increase disclosure and transparency surrounding NRSRO 

policies and procedures for issuing ratings and to increase an NRSRO’s accountability for its 

ratings, are a welcome step forward that should help to restore investor confidence in the integrity of credit ratings and, ultimately, the market as a whole. We expect to file a comment letter 

on the SEC’s latest proposal to enhance NRSRO regulation at the end of this month. 4See Securities and Exchange Commission v. Capital Gains Research Bureau, Inc., 375 U.S. 

180, 84 S. Ct. 275 (1963) (holding that Section 206 of the Investment Advisers Act of 1940 imposes a fiduciary duty on investment advisers by operation of law). 5Other participants in the money market include corporations, state and local governments, 

unregistered cash pools, commercial banks, broker-dealers, and pension funds. 

modernize regulation that has not kept pace with changes in the marketplace. 3 ICI 

supports reforms for these purposes in the areas discussed below. 

• Hedge funds and other unregulated private pools of capital. The Capital Markets Regulator should have the power to oversee hedge funds and other unregulated pooled products with respect to, at a minimum, their potential impact on 

the capital markets. For example, the Capital Markets Regulator should require 

nonpublic reporting of information, such as investment positions and strategies, 

that could bear on systemic risk and adversely impact other market participants. 

• Derivatives. The Capital Markets Regulator should have clear authority to 

adopt measures to increase transparency and reduce counterparty risk of certain over-the-counter derivatives, while not unduly stifling innovation. 

• Municipal Securities. The Capital Markets Regulator should be granted expanded authority over the municipal securities market, and should use this authority to ensure that investors have timely access to relevant and reliable information about municipal securities offerings. Currently, the SEC and the Municipal Securities Rulemaking Board are prohibited from requiring issuers of 

municipal securities to file disclosure documents before the securities are sold. 

As a result, existing disclosures are limited, non-standardized, and often stale, 

and there are numerous disparities from the corporate issuer disclosure regime. 

• Investment Advisers and Broker-Dealers. The Capital Markets Regulator 

should have explicit authority to harmonize the regulatory regimes governing 

investment advisers and broker-dealers. What once were real distinctions in the 

businesses of advisers and brokerdealers are no longer so clear, to the point 

that retail investors are largely unable to distinguish the services of an adviser 

from those of a broker-dealer. These two types of financial intermediaries, and 

their customers and clients, deserve a coherent regulatory structure that provides adequate investor protections without overlapping or unnecessary regulation. Of particular importance is devising a consistent standard of care in which 

investor protection must be paramount. The standard thus should be a high 

one. We recommend that both types of intermediaries be held to a fiduciary 

duty to their clients. 4

Recent Market Events and Money Market Funds 

Evolution and Current Significance of Money Market Funds 

Money market funds are registered investment companies that seek to maintain a stable net asset value (NAV), typically $1.00 per share. They are comprehensively 

regulated under the Investment Company Act and subject to the special requirements of Rule 2a-7 under that Act that limit the funds’ exposure to credit risk and 

market risk. 

These strong regulatory protections, administered by the SEC for nearly three 

decades, have made money market funds an effective cash management tool for retail and institutional investors. Indeed, money market funds represent one of the 

most notable product innovations in our nation’s history, with assets that have 

grown more than 2,000 percent (from about $180 billion to $3.9 trillion) since Rule 

2a-7 was adopted in 1983. Money market fund assets thus represent about one third 

of an estimated $12 trillion U.S. ‘‘money market,’’ the term generally used to refer 

to the market for debt securities with a maturity of one year or less. 5

Money market funds also are an exceptionally important source of short-term financing in the U.S. economy. They lower the cost of borrowing to the U.S. Treasury, 

businesses, and banks and finance companies by investing in a wide array of money 

market instruments. By way of example, money market funds hold roughly 40 per-
90 

6During the period from September 2007 to September 2008, many money market fund advisers or related persons did purchase structured investment vehicles from, or enter into credit 

support arrangements with, their affiliated funds to avoid any fund shareholder losses. 

cent of the commercial paper issued by U.S. corporations. In addition, tax-exempt 

money market funds are a significant source of funding for state and local governments. As of December 2008, these funds had $491 billion under management. Taxexempt money market funds held more than 20 percent of all state and local government debt outstanding. 

Money market funds seek to offer investors stability of principal, liquidity, and 

a market-based rate of return, all at a reasonable cost. Although there is no guarantee that money market funds can always achieve these objectives (and investors 

are explicitly warned of this), they have been highly successful in doing so. Since 

Rule 2a-7 was adopted over 25 years ago, $325 trillion has flowed in and out of 

money market funds. Yet only twice has a money market fund failed to repay the 

full principal amount of its shareholders’ investments. One of these instances is directly related to recent market events and is discussed below. The other occurred 

in 1994, when a small institutional money market fund ‘‘broke the buck’’ because 

it had a large percentage of its assets in adjustable-rate securities that did not return to par at the time of an interest rate readjustment. Shareholders in that fund 

ultimately received $0.96 per share (representing a 4 percent loss of principal). In 

contrast, during roughly the same time period, nearly 2,400 commercial banks and 

savings institutions have failed in the United States. 

Impact of Recent Market Events 

Until September 2008, money market funds largely had weathered severe pressures in the fixed income market that had been striking banks and other financial 

services firms since 2007. 6 That changed as a series of extraordinary events, in 

rapid succession, roiled financial markets both in the United States and around the 

globe: 

• On September 7, the U.S. Government placed Fannie Mae and Freddie Mac 

intoreceivership, wiping out shareholder equity; 

• Long-circulated rumors about the stability of Merrill Lynch, AIG, and Lehman 

Brothers gained traction; 

• Over the weekend of September 13-14, Merrill Lynch hastily arranged to be 

sold to Bank of America; 

• On September 15, the federal government declined to support Lehman Brothers, despite having arranged a buyout of Bear Stearns, a smaller investment 

bank, earlier in the year. Unable to find a buyer, Lehman declared bankruptcy; 

and 

• On September 16, the Federal Reserve Board announced a bailout of AIG, in 

which the Federal Reserve Bank of New York agreed to lend AIG up to $85 billion and to take a nearly 80 percent stake in the company. 

Beginning with news of the Lehman bankruptcy on Monday, September 15, 

money markets in the U.S. and elsewhere began to freeze, with a severity that was 

unexpected. Although Lehman’s viability had been questioned for several months, 

its failure—and that of Bear Stearns several months earlier—led to mounting concerns about the health of other financial institutions such as Wachovia, Citigroup, 

and many foreign banks. There was also growing uncertainty about whether and 

how the U.S. and foreign governments would support these institutions and their 

creditors. 

With investors running for cover, yields on Treasury securities fell, while those 

on commercial paper jumped. Inter-bank rates soared with the uncertainty about financial institutions’ exposure to Lehman and other failing financial institutions. 

Governments around the globe, attempting to calm panicked markets, injected billions of dollars of liquidity into their markets. The U.S. stock market declined nearly 5 percent on September 15 alone, reflecting broad losses to financial companies. 

Certainly the Federal Reserve seems to have been surprised by the market’s reaction to this chain of events. Appearing before this Committee on September 23, 

2008, Federal Reserve Chairman Ben Bernanke noted: 

The failure of Lehman posed risks. But the troubles at Lehman had been 

well known for some time, and investors clearly recognized—as evidenced, 

for example, by the high cost of insuring Lehman’s debt in the market for 

credit default swaps—that the failure of the firm was a significant possibility. Thus, we judged that investors and counterparties had had time to 
91 

7The AMLF provided non-recourse loans at the primary credit rate to U.S. depository institutions and bank holding companies to finance purchases of high-quality asset-backed commercial 

paper (ABCP) from money market funds. The CPFF provided a backstop to U.S. issuers of commercial paper through a special purpose vehicle that would purchase three-month unsecured 

commercial paper and ABCP directly from eligible issuers. On February 3, 2009, the Federal 

Reserve extended these and other programs for an additional six months, until October 30, 

2009. 8See Shefali Anand, ‘‘Treasury Pads Coffers in Bailout,’’ The Wall Street Journal (February 

17, 2009), available at http://online.wsj.com/article/SB123483112001495707.html 

take precautionary measures. While perhaps manageable in itself, Lehman’s default was combined with the unexpectedly rapid collapse of AIG, 

which together contributed to the development last week of extraordinarily 

turbulent conditions in global financial markets. 

Intense pressure in the money market was brought to bear, affecting all market 

participants. In the midst of this market storm, a further pressure point occurred 

for money market funds. The Lehman bankruptcy meant that securities and other 

instruments issued by Lehman became ineligible holdings for money market funds, 

in accordance with the requirements of Rule 2a-7. One such fund that held a substantial amount of Lehman Brothers commercial paper, the $62 billion Reserve Primary Fund, received $25 billion in redemption requests on September 15; the following day, September 16, its NAV dropped below $1.00 per share. News of this development, combined with investors’ broader concerns about the building stresses in 

the money market and possible failures of other financial institutions, led to heavy 

redemptions in prime money market funds as investors sought safety and liquidity 

in Treasury securities. To meet these unprecedented redemption requests, many 

money market funds were forced to sell commercial paper and other assets. It 

should be emphasized that other market participants, including unregistered cash 

pools seeking to maintain a stable NAV but not subject to Rule 2a-7, and money 

market funds in other jurisdictions, experienced difficulties as least as great as 

those experienced by U.S. registered money market funds. 

Actions by Federal Regulators To ‘‘Unfreeze’’ the Credit Markets 

The Federal Reserve and U.S. Treasury Department, seeking to cope with completely illiquid short-term fixed income markets, on September 19 announced a series of unprecedented initiatives designed to provide market stability and liquidity, 

including programs designed to support money market funds and the commercial 

paper market. The Federal Reserve established the Asset-Backed Commercial Paper 

Money Market Mutual Fund Liquidity Facility (AMLF) and the Commercial Paper 

Funding Facility (CPFF). 7 The Treasury Department announced its Temporary 

Guarantee Program for Money Market Funds, which guaranteed account balances 

as of September 19 in money market funds that signed up for, qualified for, and 

paid a premium to participate in the program. According to press reports, virtually 

all money market funds signed up for the initial term of the Treasury Temporary 

Guarantee Program. 

The government’s programs successfully bolstered investor confidence in the 

money market and in money market funds. Shortly after the programs were announced, prime money market funds stabilized and, by mid-October 2008, began to 

see inflows once again. By February 2009, owing to renewed confidence in money 

market funds at both the retail and institutional levels, assets of money market 

funds had achieved an all-time high of just less than $3.9 trillion. 

The initial three-month term of the Treasury Temporary Guarantee Program expired on December 18, 2008, but the Treasury Department extended the program 

until April 30, 2009. If extended again, the program will expire by its own terms 

no later than September 18, 2009. At the time of this hearing, an estimated $813 

million has been paid in premiums. 8 There has been—and we are hopeful that there 

will be—no occasion for the Treasury Guarantee Program to pay any claim. Assuming continued progress in restoring the health of the money market, we would not 

anticipate any need to extend the Treasury Guarantee Program beyond the one-year 

maximum period. 

Industry-Led Reform Initiative 

The market events described above have brought into sharp focus the significance 

of money market funds and the critical role they play as a low-cost funding vehicle 

for the American economy. To us, these events and their impact also signaled a need 

to devote serious effort to capturing the lessons learned—by conducting a thorough 

examination of how the money market can function better, and how all funds operating in that market, including registered money market funds, should be regulated. 
92 

1 ICI has formed a Money Market Working Group that is developing recommendations to improve the functioning of the money market and the operation and regulation of funds investing 

in that market. The group will identify needed improvements in market and industry practices; 

regulatory reforms, including improvements to SEC rules governing money market funds; and 

To that end, in November 2008 ICI formed a Money Market Working Group, led 

by John J. Brennan, Chairman of The Vanguard Group. The Working Group was 

given a broad mandate to develop recommendations to improve the functioning of 

the money market as a whole, and the operation and regulation of funds investing 

in that market. The Working Group intends to report its findings, conclusions, and 

recommendations later this month, and we look forward to sharing that information 

with the Committee at that time. We believe that prompt implementation of the 

Working Group’s recommendations will help assure a smooth transition away from 

the Treasury Guarantee Program. 

Conclusion 

ICI applauds the Committee for its diligent efforts on the very important issues 

discussed above, and we thank you for the opportunity to testify. We believe our 

recommendations for reforming financial services regulation would have significant 

benefits for investors and the capital markets. We look forward to continuing to 

work with the Committee and its staff on these matters. 

APPENDIX A 

Investment Company Institute Financial Services Regulatory Reform: Discussion and 

Recommendations—March 3, 2009 

EXECUTIVE SUMMARY 

Today’s financial crisis has demonstrated that the current system for oversight of 

U.S. financial institutions is insufficient to address modern financial markets. Yet 

it also affords policymakers with the public mandate necessary to take bold steps 

to strengthen and modernize regulatory oversight of the financial services industry. 

In this paper, the Investment Company Institute (ICI), the national association of 

U.S. investment companies, offers its recommendations on how to achieve meaningful reforms, with particular emphasis on those reforms that most directly affect the 

functioning of the capital markets and the regulation of investment companies (also 

referred to as ‘‘funds’’). 

To improve the U.S. government’s capability to monitor and mitigate risks across 

our nation’s financial system, ICI supports the designation of a new or existing 

agency or inter-agency body as a ‘‘Systemic Risk Regulator.’’ As the financial crisis 

has shown, our system is vulnerable to risks that have the potential to spread rapidly throughout the system and cause significant damage. The Systemic Risk Regulator should have responsibility for: (1) monitoring the financial markets broadly; 

(2) analyzing changing conditions in domestic and overseas markets; (3) evaluating 

the risks of practices as they evolve and identifying those that are of such nature 

and extent that they implicate the health of the financial system at large; and (4) 

acting to mitigate such risks in coordination with other responsible regulators. At 

the same time, very careful consideration should be given to the specifics of how the 

Systemic Risk Regulator will be authorized to perform its functions and how it will 

relate to other financial regulators. 

More broadly, ICI recommends changes to create a regulatory framework that enhances regulatory efficiency, limits duplication, closes regulatory gaps, and emphasizes the national character of the financial services industry. A new ‘‘Capital Markets Regulator’’ should encompass the combined functions of the Securities and Exchange Commission and the Commodity Futures Trading Commission, thus creating 

a single independent federal regulator responsible for oversight of U.S. capital markets, market participants, and all financial investment products. Also to achieve 

these goals, ICI recommends that Congress consider consolidation of the regulatory 

structure for the banking sector and authorization of an optional federal charter for 

insurance companies. Such a regulatory framework—with one or more dedicated 

regulators to oversee each major financial services sector—would maintain specialized regulatory focus and expertise, as well as avoid the potential for one industry 

sector to take precedence over the others in terms of regulatory priorities or the allocation of resources. 

To preserve regulatory efficiencies achieved under the National Securities Markets Improvement Act of 1996, Congress should affirm the role of the Capital Markets Regulator as the regulatory standard setter for all registered investment companies. The Capital Markets Regulator’s jurisdiction should include money market 

funds. 1 ICI further envisions the Capital Markets Regulator as the first line of de-
93 

possibly legislative proposals. The Working Group expects to report its recommendations in the 

first quarter of 2009. 2See, e.g., The Department of the Treasury Blueprint for a Modernized Financial Regulatory 

Structure (March 2008) (‘‘Treasury Blueprint’’), available at http://www.treas.gov/press/releases/reports/Blueprint.pdf; Report and Recommendations: Commission on the Regulation of 

U.S. Capital Markets in the 21st Century, U.S. Chamber of Commerce (March 2007), available 

at http://www.capitalmarketscommission.com/portal/capmarkets/default.htm; Sustaining New 

York’s and the US’ Global Financial Services Leadership (report by McKinsey & Co., Jan. 2007), 

at http://www.senate.gov/schumer/SchumerWebsite/pressroom/speciallreports/2007/ 

NYlREPORT%20lFINAL.pdf; Interim Report of the Committee on Capital Markets Regulation (Nov. 30, 2006), available on the Committee’s Web site at http://www.capmktsreg.org/research.html 

fense with respect to risks across the capital markets. The new agency should be 

granted explicit authority to regulate in certain areas where there are currently 

gaps in regulation—in particular, with regard to hedge funds, derivatives, and municipal securities—and explicit authority to harmonize the legal standards applicable to investment advisers and broker-dealers. In performing its mission, the Capital Markets Regulator should maintain a sharp focus on investor protection and 

law enforcement. It also should be required to carefully consider the impact of its 

rulemaking activity on efficiency, competition and capital formation. 

Establishing the Capital Markets Regulator presents a very valuable opportunity 

to ‘‘get it right’’ in terms of how the agency is organized and managed. It is imperative, for example, that the Capital Markets Regulator be able to keep current with 

market and industry developments and understand their impact on regulatory policy. Ways to achieve this end include hiring more agency staff with significant prior 

industry experience and establishing a multidisciplinary ‘‘Capital Markets Advisory 

Committee’’ comprised of private sector representatives from all major sectors of the 

capital markets. There should be a high-level focus on agency management, perhaps 

through the designation of a Chief Operating Officer. To perform effectively, the 

agency must have open and effective lines of internal communication, and mechanisms to facilitate internal coordination and information sharing. We further suggest that the agency would benefit from a comprehensive process for setting regulatory priorities and assessing progress. 

Finally, if a new U.S. financial regulatory structure is to be successful in protecting the interests of our nation’s savers and investors, there is a critical need for 

effective coordination and information sharing among the financial regulators, including in particular the Systemic Risk Regulator. Stronger links between regulators and an overriding sense of shared purpose would greatly assist in sound policy development, prioritization of effort, and cooperation with the international regulatory community. ICI observes that the President’s Working Group on Financial 

Markets, with certain modifications, may be the most logical mechanism through 

which to accomplish this purpose. 

We strongly believe that the future of the fund industry depends upon the existence of strong, wellregulated financial institutions operating within a well-regulated 

financial marketplace that will promote investor confidence, attract global financial 

business, and enable our institutions to compete more effectively. ICI looks forward 

to working with other stakeholders and policymakers to strengthen the U.S. financial services regulatory system and to improve its ability to meet new challenges 

posed by the continuing evolution of the financial markets, market participants, and 

financial products. 

Introduction 

Well before mainstream Americans felt the widespread effects of the current financial crisis, many policymakers and commentators were calling for financial services regulatory reform. 2 These efforts reflected general agreement that our current 

organization for oversight of financial institutions is insufficient to address modern 

financial markets. Recent market events have served to put into much sharper focus 

the many weaknesses of the current system and the many important linkages that 

exist between and among the U.S. financial markets and the markets of other developed nations. 

Yet the current financial crisis also offers an important opportunity—the chance 

to have a frank and robust public dialogue about what works and what does not. 

It further affords policymakers with the public mandate necessary to take bold steps 

to strengthen and modernize regulatory oversight of the financial services industry. 

The debate over financial services regulatory reform will require careful consideration of a multitude of complicated and interconnected issues, and there are many 

stakeholders in the eventual outcomes of this debate—most importantly, the nation’s savers and investors. In this paper, the Investment Company Institute (ICI), 
94 

3 ICI members include mutual funds, closed-end funds, exchange-traded funds (ETFs) and 

unit investment trusts (UITs). 

the national association of U.S. investment companies, 3 offers its recommendations 

on how to achieve meaningful reform of financial services regulation. We give particular emphasis to reforms that most directly affect the functioning of the capital 

markets and the regulation of investment companies (also referred to as ‘‘funds’’). 

Investment companies have a unique perspective on our regulatory system, as 

both issuers of securities and investors in domestic and international securities markets. It has been our experience that, in large measure, the needs of issuers and 

investors are aligned—that both will benefit from broad and efficient markets, 

transparency of information, strong investor protections, and within that context, 

the elimination of unnecessary regulatory impediments to innovation. 

We strongly believe that the future of our industry depends upon the existence 

of strong, well-regulated financial institutions operating within a well-regulated financial marketplace that will promote investor confidence, attract global financial 

business and enable our institutions to compete more effectively. The reforms suggested in this paper should help to build and foster such a financial system. 

Our recommendations and the benefits they are designed to achieve are summarized in Section II below. We elaborate on our recommendations in Section III (Establishment of a Systemic Risk Regulator), Section IV (Formation of a New Capital 

Markets Regulator), Section V (Regulatory Structure Affecting Other Financial Institutions), and Section VI (Enhanced Inter-agency Coordination and Information 

Sharing). In Section VII, we discuss in detail the expected benefits from these reforms. 

A host of different reform proposals are being advanced—by the new Administration, members of Congress, industry groups, academics, and others. ICI will closely 

follow these developments and participate in this debate on behalf of the fund industry. We also may refine as appropriate the views expressed in this paper. 

Summary of Recommendations and Expected Benefits 

Recommendations for Reform 

ICI recommends that Congress: 

• Designate a new or existing agency or inter-agency body to act as a Systemic 

Risk Regulator. 

• Establish a new Capital Markets Regulator encompassing the combined functions of the Securities and Exchange Commission and the Commodity Futures 

Trading Commission. The Capital Markets Regulator should: 

• be the regulatory standard setter for all registered investment companies, 

including money market funds; 

• have explicit authority to regulate in certain areas where there are currently gaps in regulation and to harmonize the legal standards that apply 

to investment advisers and broker-dealers; 

• maintain a sharp focus on investor protection and law enforcement; 

• carefully consider as well the impact of its rulemaking activity on efficiency, 

competition and capital formation; 

• serve as the first line of defense with respect to risks across the capital 

markets as a whole; and 

• take proactive steps to maximize its continuing effectiveness, including: establishing the conditions necessary for ongoing dialogue with the regulated 

industry; establishing mechanisms to stay abreast of market/industry developments; and developing strong capability to conduct economic analysis to 

support sound rulemaking and oversight. 

• Consider consolidation of the regulatory structure for the banking sector. 

• Authorize an optional federal charter for insurance companies. 

• Enhance inter-agency coordination and information sharing efforts, including by 

modernizing the Executive Order authorizing the President’s Working Group on 

Financial Markets. 

Expected Benefits of These Reforms 

ICI believes the principal benefits of these reforms would be to: 

• Improve the U.S. government’s capability to monitor and mitigate risks across 

our nation’s financial system. 
95 

4See Frank Calls for Significant Changes in Financial Services Regulation, Press Release 

(March 20, 2008), available at http://financialservices.house.gov/press110/press0320082.shtml. 

Likewise, the Treasury Blueprint issued shortly thereafter suggested that an optimal regulatory 

structure would include the designation of a market stability regulator responsible for overall 

issues of financial market stability. 5See Remarks of Senator Barack Obama: Renewing the American Economy, New York, NY 

(March 27, 2008), available at http://www.barackobama.com/2008/03/27/remarksloflsenatorlbaracklobaml54.php 6See, e.g., Peter J. Wallison, Regulation Without Reason: The Group of Thirty Report, AEI 

Financial Services Outlook (Jan. 2009), available at http://www.aei.org/publications/ 

pubID.29285/publdetail.asp 

• Create a regulatory framework that enhances regulatory efficiency, limits duplication, and emphasizes the national character of the financial services industry. 

• Close regulatory gaps to ensure appropriate oversight of all market participants 

and investment products. 

• Preserve specialized regulatory focus and expertise and avoid potential uneven 

attention to different industries or products. 

• Foster a culture of close consultation and dialogue among U.S. financial regulators to facilitate collaboration on issues of common concern. 

• Facilitate coordinated interaction with regulators in other jurisdictions, including with regard to risks affecting global capital markets. 

Establishment of a Systemic Risk Regulator 

Over the past year, various policymakers and other commentators have called for 

the establishment of a formal mechanism for identifying, monitoring, and managing 

risks to the financial system as a whole. For example, in a March 2008 speech, 

House Financial Services Committee Chairman Barney Frank (D-MA) recommended 

that Congress consider establishing a ‘‘Financial Services Systemic Risk Regulator’’ 

that has the capacity and power to assess risk across financial markets and to intervene when appropriate. 4 Around the same time, then-Senator Barack Obama highlighted the need for a process that identifies systemic risks to the financial system. 5

The deepening financial crisis has further exposed the vulnerability of our financial system to risks that have the potential to spread rapidly throughout the system 

and cause significant damage. It has led to a growing consensus that bold steps are 

needed to equip regulators to better anticipate and address such risks. Analyses of 

the causes of the current crisis suggest that systemic risks may be occasioned by, 

for example: (1) excessive leveraging by financial institutions; (2) a lack of transparency regarding risky practices; and (3) institutions or activities that fall through 

gaps in the regulatory framework. Systemic risks—whether they are attributable to 

excessive risk taking by some market participants or to other causes—can negatively impact investment companies, thereby making it more difficult for their 

shareholders to achieve important financial goals. 

Subject to important cautions, ICI supports the designation of a new or existing 

agency or inter-agency body as a ‘‘Systemic Risk Regulator.’’ Broadly stated, the goal 

in establishing a Systemic Risk Regulator should be to provide greater overall stability to the financial system as a whole. The Systemic Risk Regulator should have 

responsibility for: (1) monitoring the financial markets broadly; (2) analyzing changing conditions in domestic and overseas markets; (3) evaluating the risks of practices as they evolve and identifying those that are of such nature and extent that 

they implicate the health of the financial system at large; and (4) acting to mitigate 

such risks in coordination with other responsible regulators. 

Very careful consideration must be given to the specifics of how the Systemic Risk 

Regulator will be authorized to perform its functions. In particular, the legislation 

establishing the Systemic Risk Regulator should be crafted to avoid imposing undue 

constraints or inapposite forms of regulation on normally functioning elements of 

the financial system, or stifling innovations, competition or efficiencies. By way of 

example, it has been suggested that a Systemic Risk Regulator could be given the 

authority to identify financial institutions that are ‘‘systemically significant’’ and to 

oversee those institutions directly. Despite its seeming appeal, such an approach 

could have very serious anticompetitive effects if the identified institutions were 

viewed as ‘‘too big to fail’’ and thus judged by the marketplace as safer bets than 

their smaller, ‘‘less significant’’ competitors. 6

Additionally, the Systemic Risk Regulator should not be structured to simply add 

another layer of bureaucracy or to displace the primary regulator(s) responsible for 

capital markets, banking or insurance. Legislation establishing the Systemic Risk 

Regulator thus should define the nature of the relationship between this new regulator and the primary regulator(s) for each industry sector. This should involve plac-
96 

7The term ‘‘credit risk’’ refers to the exposure of securities, through default or otherwise, to 

risks associated with the creditworthiness of the issuer. The term ‘‘market risk’’ refers to the 

exposure of securities to significant changes in value due to changes in prevailing interest rates. 8Money market funds had assets of approximately $3.9 trillion under management as of February 2009. 9 Currently, regulatory oversight of both the securities and futures industries involves various 

self-regulatory organizations. In establishing the Capital Markets Regulator, Congress will need 

to determine the appropriate role for any such organization(s). 

ing explicit limitations on the extent of the authority granted to the Systemic Risk 

Regulator, as well as identifying specific areas in which the Systemic Risk Regulator 

and primary regulator(s) should work together. We believe, for example, that the 

primary regulators have a critical role to play by acting as the first line of defense 

with regard to detecting potential risks within their spheres of expertise. 

How these issues are resolved will have a very real impact on registered investment companies, as both issuers and investors in the capital markets. Money market funds, for example, are comprehensively regulated under the Investment Company Act of 1940 and subject to special requirements that limit the fund’s exposure 

to credit risk and market risk. 7 These strong regulatory protections, administered 

by the SEC for nearly three decades, have made money market funds an effective 

cash management tool for retail and institutional investors and an important source 

of short-term financing for American business and municipalities. Given the size of 

this industry segment 8 and its important role in our nation’s money markets, 

money market funds are likely to be on the radar screen of the Systemic Risk Regulator as it monitors the financial markets. The type of information about money 

market funds that the Systemic Risk Regulator may need to perform this function, 

and how the regulator will obtain that information, are just two of the specific 

issues that will need to be carefully considered. As a threshold matter, however, ICI 

firmly believes that regulation and oversight of money market funds must be the 

province of the Capital Markets Regulator. 

ICI will closely follow the debate over the establishment of a Systemic Risk Regulator, and will inform policymakers as to the fund industry’s views of future proposals. 

Formation of a New Capital Markets Regulator 

Currently, securities and futures are subject to separate regulatory regimes under 

different federal regulators. This system reflects historical circumstances that have 

changed significantly. As recently as the mid-1970s, for example, agricultural products accounted for most of the total U.S. futures exchange trading volume. By the 

late 1980s, a shift from the predominance of agricultural products to financial instruments and currencies was readily apparent in the volume of trading on U.S. futures exchanges. In addition, as new, innovative financial instruments were developed, the lines between securities and futures often became blurred. The existing, 

divided regulatory approach has resulted in jurisdictional disputes, regulatory inefficiency, and gaps in investor protection. With the increasing convergence of securities 

and futures products, markets, and market participants, the current system makes 

little sense. To bring a consistent policy focus to U.S. capital markets, we recommend the creation of a Capital Markets Regulator as a new agency that would 

encompass the combined functions of the SEC and the CFTC. 

As the federal regulator responsible for overseeing all financial investment products, it is imperative that the Capital Markets Regulator—like the SEC and the 

CFTC—be established by Congress as an independent agency, with an express statutory mission and the rulemaking and enforcement powers necessary to carry out 

that mission. 9 A critical part of that mission should be for the new agency to maintain a sharp focus on investor protection and law enforcement. And Congress should 

ensure that the agency is given the resources it needs to fulfill its mission. Most 

notably, the Capital Markets Regulator must have the ability to attract personnel 

with the necessary market experience to fully grasp the complexities of today’s global marketplace. 

Scope of Authority 

ICI recommends that the Capital Markets Regulator assume on an integrated 

basis the responsibilities currently handled by the SEC and the CFTC. For the SEC, 

those functions include requiring public companies to disclose financial and other 

information to the public; overseeing various market participants, including securities exchanges, broker-dealers, investment advisers, and investment companies; and 

enforcing the securities laws. The SEC also oversees the setting of accounting standards for public companies. For its part, the CFTC regulates the commodity futures 

and option markets. It oversees various entities including exchanges, clearing facili-
97 

10 Joint Explanatory Statement of the Committee of Conference, Conference Report—National 

Securities Markets Improvement Act of 1996, H.R. 3005, H.R. Conf. Rep. No. 104-864 (1996). 11 ICI has formed a Money Market Working Group that is developing recommendations to improve the functioning of the money market and the operation and regulation of funds investing 

in that market. The group will identify needed improvements in market and industry practices; 

regulatory reforms, including improvements to SEC rules governing money market funds; and 

possibly legislative proposals. The Working Group expects to report its recommendations in the 

first quarter of 2009. 

ties, and market participants such as futures commission merchants, commodity 

pool operators, and commodity trading advisors. Through its oversight and enforcement powers, it seeks to protect market users and the public from fraud, manipulation, and abusive practices. 

Of particular importance to the fund industry is to ensure that the Capital Markets Regulator is authorized: (1) to act as the regulatory standard setter for all registered investment companies, as is the case now with the SEC; (2) to regulate in 

certain areas where there are currently gaps that have the potential to impact the 

capital markets and market participants; and (3) to regulate broker-dealers and investment advisers in a consistent manner when they provide similar services to investors. 

1. Regulation of Registered Investment Companies: In creating the new regulator, 

Congress should take note of the important benefits that have flowed from the 

shared system of federal-state oversight established by the National Securities Markets Improvement Act of 1996 (NSMIA). Under this system, federal law governs all 

substantive regulation of investment companies and states have concurrent authority to protect against fraud. NSMIA represented the judgment of Congress that ‘‘the 

system of dual federal and state securities regulation ha[d] resulted in a degree of 

duplicative and unnecessary regulation . . . that, in many instances, [was] redundant, costly, and ineffective.’’ 10 In recognition of the national character of the market in which investment companies operate, and to secure the regulatory efficiencies 

Congress intended, Congress should affirm the role of the Capital Markets Regulator as the regulatory standard setter for registered investment companies. The 

Capital Markets Regulator’s regulatory jurisdiction should include the authority to 

regulate money market funds. 11

2. Regulatory Gaps: The Capital Markets Regulator should have express regulatory authority in the following areas: 

• Hedge funds and other unregulated private pools of capital. The Capital Markets Regulator should be authorized to provide oversight over hedge funds and 

other unregulated pooled products with respect to, at a minimum, their potential impact on the capital markets (e.g., require nonpublic reporting of information such as investment positions and strategies that could bear on systemic 

risk and adversely impact other market participants). 

• Derivatives. The Capital Markets Regulator should have clear authority to 

adopt measures to increase transparency and reduce counterparty risk of certain over-the-counter derivatives, while not unduly stifling innovation. 

• Municipal Securities. The Capital Markets Regulator should be granted expanded authority over the municipal securities market, and use this authority 

to ensure that investors have timely access to relevant and reliable information 

about municipal securities offerings. Currently, the SEC and the Municipal Securities Rulemaking Board are prohibited from requiring issuers of municipal 

securities to file disclosure documents before the securities are sold. As a result, 

existing disclosures are limited, non-standardized and often stale, and there are 

numerous disparities from the corporate issuer disclosure regime. 

3. Regulation of Investment Advisers and Broker-Dealers: The Capital Markets 

Regulator also should have explicit authority to harmonize the regulatory regimes 

governing investment advisers and broker-dealers. What once were real distinctions 

in the businesses of advisers and broker-dealers are no longer so clear, to the point 

that retail investors are largely unable to distinguish the services of an adviser from 

those of a broker-dealer. These two types of financial intermediaries, and their customers and clients, deserve a coherent regulatory structure that provides adequate 

investor protections—including, in particular, a consistent standard of care—without overlapping or unnecessary regulation. 

Mission 

The SEC describes its mission as ‘‘to protect investors, maintain fair, orderly and 

efficient markets, and facilitate capital formation.’’ For its part, the CFTC states 

that its mission is ‘‘to protect market users and the public from fraud, manipulation 
98 

12 Curiously, the SEC’s description of its own mission (see http://www.sec.gov/about/ 

whatwedo.shtml) omits any reference to promoting competition—notwithstanding the specific requirement under NSMIA to consider this factor. 

and abusive practices related to the sale of commodity and financial futures and options, and to foster open, competitive, and financially sound futures and options 

markets.’’ The differing focus expressed in these two mission statements is reflective 

of historical distinctions in the securities and futures industries, including with regard to the purposes of their respective markets and the participants in those markets. As growing convergence within these two industries suggests the creation of 

a unified regulator for the capital markets, it is important to consider how the mission statement for the new regulator can best reflect this convergence. 

From the perspective of the fund industry, the mission of the Capital Markets 

Regulator must involve maintaining a sharp focus on investor protection, supported 

by a comprehensive enforcement program. This core feature of the SEC’s mission 

has consistently distinguished the agency from the banking regulators, who are 

principally concerned with the safety and soundness of the financial institutions 

they regulate, and it has generally served investors well over the years. 

At the same time, the SEC is required by NSMIA to consider, in determining 

whether a proposed regulation is consistent with the public interest, both the protection of investors and whether the regulation would promote efficiency, competition 

and capital formation. This NSMIA requirement suggests that Congress did not 

view investor protection and efficiency, competition, and capital formation as being 

competing considerations, but rather determined that each is relevant to the development of sound capital markets regulation. We strongly believe that the Capital 

Markets Regulator should be subject to the same requirements. 12 Investors are not 

well served, for example, by rulemaking actions that create significant inefficiencies 

or have anti-competitive effects in the marketplace, which ultimately result in increased costs for investors. 

Combining the market-related missions of the SEC and CFTC should be more 

straightforward. Generally speaking, each agency is called upon to maintain the integrity of the markets under its jurisdiction. The same must be true for the new 

Capital Markets Regulator. As the ongoing financial crisis demonstrates, it is imperative that the task of maintaining market integrity be viewed broadly to include 

monitoring and addressing risks across the markets as a whole. Formally assigning 

some level of responsibility to the Capital Markets Regulator in this area makes 

sense. Given its expertise and its position as the primary regulator of these markets, the Capital Markets Regulator can serve as the first line of defense with regard to detecting problems in the capital markets. While this approach could result 

in some potential overlap with the responsibilities of the Systemic Risk Regulator, 

we believe that any inefficiencies may be minimized through effective coordination 

and information sharing. 

Agency Management and Organization 

It is axiomatic in the private sector that a company’s success is directly related 

to the soundness of its management. The same principle holds true for public sector 

entities. But management improvements take time and serious attention, not to 

mention allocation of resources. Given that they often experience frequent turnovers 

in leadership and strained resources, it is not surprising that government agencies 

can find it particularly difficult to undertake and sustain significant management 

reforms. Establishing a new agency presents a very valuable opportunity to ‘‘get it 

right’’ as part of that process. 

There is also an opportunity to make sound decisions up-front about how to organize the new agency. In so doing, it is important not to simply use the current structure of the SEC and/or the CFTC as a starting point. In the case of the SEC, for 

example, its current organizational structure largely took shape in the early 1970s 

and reflects the operation of the securities markets of that day. Rather, the objective 

should be to build an organization that not only is more reflective of today’s markets, market participants and investment products, but also will be flexible enough 

to regulate the markets and products of tomorrow. 

We offer the following thoughts with regard to management and organization of 

the Capital Markets Regulator: 

• Ensure high-level focus on agency management. One approach would be to designate a Chief Operating Officer for this purpose. 

• Implement a comprehensive process for setting regulatory priorities and assessing progress. It may be helpful to draw upon the experience of the United Kingdom’s Financial Services Authority, which seeks to follow a methodical ap-
99 

proach that includes developing a detailed annual business plan establishing 

agency priorities and then reporting annually the agency’s progress in meeting 

prescribed benchmarks. 

• Promote open and effective lines of communication among the regulator’s Commissioners and between its Commissioners and staff. Such communication is 

critical to fostering awareness of issues and problems as they arise, thus increasing the likelihood that the regulator will be able to act promptly and effectively. A range of approaches may be appropriate to consider in meeting this 

goal, including whether sufficient flexibility is provided under the Government 

in the Sunshine Act, and whether the number of Commissioners should be 

greater than the current number at the SEC and at the CFTC (currently, each 

agency has five). 

• Align the inspections and examinations functions and the policymaking divisions. This approach would have the benefit of keeping staff in the policymaking 

divisions updated on current market and industry developments, as well as precluding any de facto rulemaking by the regulator’s inspections staff. 

• Develop mechanisms to facilitate coordination and information sharing among 

the policymaking divisions. These mechanisms would help to ensure that the 

regulator speaks with one voice. 

Additional Steps To Maximize Effectiveness 

ICI believes that the following proactive steps will greatly enhance the ability of 

the Capital Markets Regulator to fulfill its mission successfully when carrying out 

its regulatory responsibilities and should be priorities for the new agency. 

1. Establish the conditions necessary for constructive, ongoing dialogue with the 

regulated industry: The Capital Markets Regulator should seek to facilitate closer, 

cooperative interaction with the entities it regulates to identify and resolve problems, to determine the impact of problems or practices on investors and the market, 

and to cooperatively develop best practices that can be shared broadly with market 

participants. Incorporating a more preventative approach would likely encourage 

firms to step forward with self-identified problems and proposed resolutions. The net 

result is that the Capital Markets Regulator would pursue its investor protection 

responsibilities through various means not always involving enforcement measures, 

although strong enforcement must remain an important weapon in the regulator’s 

arsenal. 

2. Establish mechanisms to stay abreast of market and industry developments: The 

Capital Markets Regulator would benefit from the establishment of one or more external mechanisms designed to help the agency stay abreast of market and industry 

issues and developments, including developments and practices in non-U.S. jurisdictions as appropriate. For example, several federal agencies—including both the SEC 

and CFTC—utilize a range of advisory committees. Such committees, which generally have significant private sector representation, may be established to provide 

recommendations on a discrete set of issues facing the agency (e.g., the SEC’s Advisory Committee on Improvements to Financial Reporting) or to provide regular information and guidance to the agency (e.g., the CFTC’s Agricultural Advisory Committee). 

ICI believes that a multidisciplinary ‘‘Capital Markets Advisory Committee’’ could 

be a very effective mechanism for providing the Capital Markets Regulator with 

‘‘real world’’ perspectives and insights on an ongoing basis. We recommend that 

such a committee be comprised primarily of private sector representatives from all 

major sectors of the capital markets, and include one or more members representing 

funds and asset managers. Additionally, the Capital Markets Advisory Committee 

should be specifically established in, and required by, the legislation creating the 

Capital Markets Regulator. Such a statutory mandate would emphasize the importance of this advisory committee to the agency’s successful fulfillment of its mission. 

The establishment of an advisory committee would complement other efforts by 

the Capital Markets Regulator to monitor developments affecting the capital markets and market participants. These efforts should include, first and foremost, hiring more staff members with significant prior industry experience. Their practical 

perspective would enhance the agency’s ability to keep current with market and industry developments and better understand the impact of such developments on regulatory policy. 

3. Apply reasonably comparable regulation to like products and services: Different 

investment products often are subject to different regulatory requirements, often 

with good reason. At times, however, heavier regulatory burdens have been placed 

on funds than on other investment products that share similar features and are sold 

to the same customer base. It does not serve investors well if the regulatory require-
100 

13See, e.g., Special Report on Regulatory Reform, Congressional Oversight Panel (submitted 

under Section 125(b)(2) of Title I of the Emergency Economic Stabilization Act of 2008) (Jan. 

2009) (‘‘In tailoring regulatory responses . . . the goal should always be to strike a reasonable 

balance between the costs of regulation and its benefits. Just as speed limits are more stringent 

on busy city streets than on open highways, financial regulation should be strictest where the 

threats—especially the threats to other citizens—are greatest, and it should be more moderate 

elsewhere.’’). 

ments placed on funds—however well-intentioned—end up discouraging investment 

advisers from entering or remaining in the fund business, dissuading portfolio managers from managing funds as opposed to other investment products, or creating 

disincentives for brokers and other intermediaries to sell fund shares. It is critically 

important for the Capital Markets Regulator to be sensitive to this dynamic in its 

rulemakings. Among other things, in analyzing potential new regulatory requirements for funds, the Capital Markets Regulator should consider whether other investment products raise similar policy concerns and thus should be subject to comparable requirements. 

4. Develop strong capability to conduct economic analysis to support sound rulemaking and oversight: The Capital Markets Regulator will be best positioned to accomplish its mission if it conducts economic analysis in various aspects of the agency’s work, including rulemaking, examinations, and enforcement. Building strong 

economic research and analytical capabilities is an important way to enhance the 

mix of disciplines that will inform the agency’s activities. From helping the agency 

look at broad trends that shed light on how markets or individual firms are operating to enabling it to demonstrate that specific policy initiatives are well-grounded, 

developing the agency’s capability to conduct economic analysis will be well worth 

the long-term effort required. The agency should consider having economists resident in each division to bring additional, important perspectives to bear on regulatory challenges. 

It is important that economic analysis play an integral role in the rulemaking 

process, because many regulatory costs ultimately are borne by investors. When new 

regulations are required, or existing regulations are amended, the Capital Markets 

Regulator should thoroughly examine all possible options and choose the alternative 

that reflects the best trade-off between costs to, and benefits for, investors. Effective 

cost-benefit analysis does not mean compromising protections for investors or the 

capital markets. Rather, it challenges the regulator to consider alternative proposals 

and think creatively to achieve appropriate protections while minimizing regulatory 

burdens, or to demonstrate that a proposal’s costs and burdens are justified in light 

of the nature and extent of the benefits that will be achieved. 13

5. Modernize regulations that no longer reflect current market structures and practices: Financial markets and related services are constantly evolving, frequently at 

a pace that can make the regulations governing them (or the rationale behind those 

regulations) become less than optimal, if not entirely obsolete. Requiring industry 

participants to comply with outmoded regulations imposes unnecessary costs on 

both firms and investors, may impede innovation, and, most troubling of all, could 

result in inadequate protection of investors. It is thus important that the Capital 

Markets Regulator engage in periodic reviews of its existing regulations to determine whether any such regulations should be modernized or eliminated. 

6. Give heightened attention to investor education: During the course of their lives, 

investors are called upon to make a variety of investment decisions as their personal 

circumstances change. These decisions may involve saving to buy a home or to finance a child’s education, building an adequate nest egg for retirement, or investing 

an inheritance, to name a few. Whether they make their investment decisions individually or with the help of a financial adviser, investors need to be able to make 

informed decisions based upon their individual needs. 

The recent turmoil in the financial markets has underscored how important it is 

that investors be knowledgeable and understand their investments. Well-informed 

investors are more likely to develop realistic expectations, take a long-term perspective, and understand the trade-off between risk and reward. They are less likely to 

panic and make mistakes. 

To better equip investors to make good decisions about their investments, the 

Capital Markets Regulator should assign a high priority to pursuing regulatory initiatives that will help educate investors. The SEC’s new rule allowing mutual funds 

and exchange-traded funds to provide a ‘‘summary prospectus’’ containing key fund 

information to investors—while making additional information available online or 

by mail or e-mail upon request—is an excellent example of a forward thinking approach to better informing investors. It should serve as a model for future disclosure 

improvement efforts, such as reform of fund shareholder reports. Regulatory efforts 
101 

14See SEC, CFTC Sign Agreement to Enhance Coordination, Facilitate Review of New Derivative Products (SEC press release dated March 11, 2008), available at http://www.sec.gov/ 

news/press/2008/2008-40.htm 

to promote investor education also should extend beyond funds. Investors who purchase other types of investment products or services, such as separately managed 

accounts, likewise would benefit from clear, concise, understandable disclosure. In 

addition, appropriately fashioned point of sale disclosure would help investors in all 

types of retail investment products assess and evaluate broker recommendations. 

The SEC has an Office of Investor Education and Advocacy and provides some investor education resources on its Web site. These types of efforts should be expanded, possibly in partnership with other governmental or private entities, and 

better publicized. Many industry participants, too, have developed materials and 

other tools to help educate investors; additional investor outreach efforts should be 

encouraged. 

Process of Merging the SEC and CFTC 

Legislation to merge the SEC and CFTC should outline a process by which to harmonize the very different regulatory philosophies of the two agencies, as well as to 

rationalize their governing statutes and current regulations. We note that there is 

potential peril in leaving open-ended the process of merging the two agencies. We 

accordingly recommend that the legislation creating the Capital Markets Regulator 

set forth a specific timetable, with periodic benchmarks and accountability requirements, so as to ensure that the merger of the SEC and CFTC is completed as expeditiously as possible. 

The process of merging the two agencies will be lengthy, complex, and have the 

potential to disrupt the functioning of the SEC, CFTC, and their regulated industries. We suggest that, in anticipation of the merger, the SEC and CFTC undertake 

detailed consultation on all relevant issues and take all steps possible toward greater harmonization of the agencies. This work should be facilitated by the Memorandum of Understanding the two agencies signed last year regarding coordination 

in areas of common regulatory interest. 14 ICI believes that its recommendations 

with respect to the Capital Markets Regulator may provide a helpful framework for 

these efforts. 

Regulatory Structure Affecting Other Financial Institutions 

Earlier in this paper, we have recommended the establishment of a Systemic Risk 

Regulator, and we have discussed at length the need for a new Capital Markets 

Regulator to oversee markets and market participants in the securities and futures 

industries. In this section and the one immediately following, we comment briefly 

on reforms affecting the regulators overseeing other sectors of the U.S. financial system (specifically, banking and insurance) and how all regulators within the system 

can work together more effectively. 

Regulation of the banking and insurance industries is, quite obviously, not ICI’s 

primary area of focus. That said, regulation of these industries greatly affects the 

performance of the U.S. financial system as a whole and the ability of investment 

companies to function within that system. 

ICI believes it is important, therefore, for policymakers to carefully consider how 

to achieve a more rational regulatory structure for the banking sector that consolidates duplicative regulatory agencies and clarifies regulatory missions. Any such 

analysis would no doubt need to address difficult issues concerning the future role 

of state banking regulators if we are to have a more rational regulatory system at 

the national level. 

With regard to the insurance industry, ICI supports in concept the idea of creating a regulator at the federal level, a reform that has been sought by some insurance companies as a means of providing a streamlined and efficient alternative to 

the current system of state regulation. Authorizing an optional federal charter for 

insurers appears to be a logical way to bridge the gap between what exists today 

and the more comprehensive approach that is required for all financial institutions 

operating in truly national and often international markets. We also believe that a 

federal insurance regulator would provide an important and practical enhancement 

to federal inter-agency coordination and information sharing efforts, as discussed 

below. 

Enhanced Inter-Agency Coordination and Information Sharing 

A recent report examined the benefits and shortcomings of the four primary approaches to regulatory supervision currently used in jurisdictions around the 
102 

15See Group of Thirty, The Structure of Financial Supervision: Approaches and Challenges 

in a Global Marketplace (Oct. 6, 2008), available at http://www.deloitte.com/dtt/cda/doc/content/uslfsilbankinglG30%20Final%20Report%2010-3-08.pdf 16See, e.g., SEC, FRB Sign Agreement to Enhance Collaboration, Coordination, and Information Sharing (SEC press release dated July 7, 2008), available at http://www.sec.gov/news/ 

press/2008/2008-134.htm 

world. 15 The report observed that, regardless of the type of supervisory system in 

place, virtually all financial supervisors emphasized the importance of inter-agency 

coordination and information sharing for successful oversight of the financial system 

as a whole and for mitigation of systemic risk. 

Effective inter-agency coordination also plays a critical role when there is a need 

to engage on financial services regulatory issues at an international level. The variety of supervisory systems around the world and the increasing globalization of financial markets make coordination among U.S. regulatory agencies all the more important. 

In the United States at present, a variety of mechanisms are used to promote coordination and information sharing within our complex regulatory system, including 

arrangements at both the Federal and State levels and arrangements among federal 

and state agencies. These arrangements may be specifically mandated by Congress, 

such as the inter-agency Federal Financial Institutions Examination Council, or 

may be initiated by the regulators themselves, such as the July 2008 Memorandum 

of Understanding between the Federal Reserve and the SEC to foster greater coordination and information sharing. 16 One particularly important mechanism for the 

past two decades has been the President’s Working Group on Financial Markets, 

whose members are the heads of the Treasury Department, Federal Reserve, SEC 

and CFTC. As described in the Treasury Blueprint, the role of the PWG has evolved 

beyond the scope of the 1988 Executive Order creating it, so that the PWG has become a key communication and coordination mechanism for financial policy. 

If efforts to streamline the U.S. financial regulatory structure are to be successful, 

some of these coordination mechanisms would almost certainly require modification 

or perhaps would no longer be necessary. There would, however, still be a very critical need for coordination and information sharing among the remaining regulatory 

bodies, presumably with involvement in particular by the Systemic Risk Regulator. 

The President’s Working Group, with necessary modifications, would appear to be 

the easiest way to achieve this end. 

ICI concurs with the recommendation in the Treasury Blueprint that the Executive Order authorizing the PWG should be modernized ‘‘to reinforce the group’s mission and purpose . as an ongoing mechanism for coordination and communication 

on financial policy matters including systemic risk, market integrity, investor and 

consumer protection, and capital markets competitiveness.’’ We suggest that any 

new Executive Order also discuss the following additional areas where inter-agency 

coordination and information sharing are critically important: (1) the regular exchange of information about the latest market and industry developments, including 

international trends and developments; (2) the discussion of policy initiatives that 

extend across jurisdictional lines; (3) the minimization of regulatory disparities for 

like financial products and services; and (4) the need to balance financial innovation 

with appropriate market and investor protection safeguards. 

Equally important, in ICI’s view, is the role of the PWG in fostering a culture of 

close consultation and dialogue among senior officials within each regulatory sector 

that will carry over into each regulator’s dealings with one another. Stronger links 

between regulators and an overriding sense of shared purpose would greatly assist 

in sound policy development, prioritization of effort, and cooperation with the international regulatory community. 

Expected Benefits From These Reforms 

If implemented, the recommended reforms outlined above would help to establish 

a more effective and efficient regulatory structure for the U.S. financial services industry. Most significantly, these reforms would: 

• Improve the U.S. government’s capability to monitor and mitigate risks across 

our nation’s financial system. 

• Create a regulatory framework that enhances regulatory efficiency, limits duplication, and emphasizes the national character of the financial services industry. 

• Close regulatory gaps to ensure appropriate oversight of all market participants 

and investment products. 

• Preserve specialized regulatory focus and expertise and avoid potential uneven 

attention to different industries or products. 
103 

• Foster a culture of close consultation and dialogue among U.S. financial regulators to facilitate collaboration on issues of common concern. 

• Facilitate coordinated interaction with regulators in other jurisdictions, including with regard to risks affecting global capital markets. 

Of significant import to registered investment companies, creation of a consolidated Capital Markets Regulator would provide a single point of regulatory authority and consistent rulemaking and oversight for investment products, the capital 

markets, and market participants. It would create regulatory efficiencies by eliminating areas where responsibilities overlap and by ensuring against regulatory gaps 

and potential inconsistencies. A strong, integrated regulator for the capital markets 

that can see ‘‘the whole picture’’ will be better equipped to face the challenges of 

these rapidly evolving markets, and thus to protect the interests of investors. 

More generally, increased consolidation of financial services regulators, combined 

with the establishment of a Systemic Risk Regulator and more robust inter-agency 

coordination and information sharing, should facilitate monitoring and mitigation of 

risks across the financial system. It also should result in increased regulatory efficiency, including less duplication, and help to eliminate regulatory gaps. 

Consolidation of regulatory agencies also may further the competitive posture of 

the U.S. financial markets. It may make it easier to harmonize U.S. regulations 

with regulations in other jurisdictions when that is appropriate. And reducing the 

number of U.S. regulatory agencies, while also strengthening the culture of cooperation and dialogue among senior officials of the agencies, will likely facilitate coordinated interaction with regulators around the world. 

By providing for one or more dedicated regulators to oversee each major financial 

services sector, the proposed structure would maintain the specialized focus and expertise that is a hallmark of effective regulation. This structure also would allow 

appropriate tailoring of regulation to accommodate fundamental differences in regulated entities, products and activities. Additionally, it would avoid the potential for 

one industry sector to take precedence over the others in terms of regulatory priorities or approaches or the allocation of regulatory resources. 

ICI recognizes that some have criticized sector-based regulation because it may 

not provide any one regulator with a full view of a financial institution’s overall 

business, and does not give any single regulator authority to mandate actions designed to mitigate systemic risks across financial markets as a whole. Our proposed 

approach would address those concerns through the establishment of the Systemic 

Risk Regulator and specific measures to strengthen inter-agency coordination and 

information sharing. 

We further believe that retaining some elements of the current multi-agency 

structure likely would offer advantages over a single, integrated regulator approach. 

Even though a single regulator could be organized with separate units or departments focusing on different financial services sectors, it is our understanding that, 

in practice, there can be a tendency for agency staff to ‘‘gravitate’’ to certain areas 

and devote insufficient attention to financial sectors perceived to be less high profile 

or prone to fewer problems. Such a result has the potential to stifle innovation valuable to consumers and produce regulatory disparities. 

Finally, we believe that a streamlining of the current regulatory structure may 

be more effective and workable than an approach that assigns regulatory responsibilities to separate agencies based on broad regulatory objectives (e.g., market stability, safety and soundness, and business conduct). These functions often are highly 

interrelated. Not only could separating them prove quite challenging, but it would 

force regulators to view institutions in a less integrated way and to operate with 

a narrower, less informed knowledge base. For example, a Capital Markets Regulator is likely to be more effective in protecting investors if its responsibilities require it to maintain a thorough understanding of capital market operations and 

market participants. And while an objective-based structure could be one way to 

promote consistent regulation of similar financial products and services, it is not the 

only way. Under our proposed approach, minimizing regulatory disparities for like 

products and services would be an express purpose of enhanced inter-agency coordination and information-sharing efforts. 
104 

1See generally Mercer Bullard, Federally Insured Money Market Funds and Narrow Banks: 

The Path of Least Insurance (Mar. 2, 2009) available at http://ssrn.com/abstract=1351987 

PREPARED STATEMENT OF MERCER E. BULLARD 

ASSOCIATE PROFESSOR, 

UNIVERSITY OF MISSISSIPPI SCHOOL OF LAW, AND

PRESIDENT, 

FUND DEMOCRACY, INC. 

MARCH 11, 2009 

Chairman Dodd, Ranking Member Shelby, Members of the Committee, thank you 

for the opportunity to appear before you to discuss investor protection issues. It is 

an honor and a privilege to appear before the Committee today. 

I am the Founder and President of Fund Democracy, a nonprofit advocacy group 

for mutual fund shareholders, and an Associate Professor of Law at the University 

of Mississippi School of Law. I founded Fund Democracy in January 2000 to provide 

a voice and information source for mutual fund shareholders on operational and regulatory issues that affect their fund investments. Fund Democracy has attempted 

to achieve this objective in a number of ways, including filing petitions for hearings, 

submitting comment letters on rulemaking proposals, testifying on legislation, publishing articles, lobbying the financial press, and creating and maintaining an Internet Web site for the posting of information. I also have served as a consultant and 

expert witnesses for plaintiffs and defendants in a variety of securities cases, including some that are discussed in this testimony. 

This testimony focuses on investor protection issues related to investment management and investment advisory services. Some of these issues have arisen in connection with the current financial crisis, such as the question of prudential regulation of money market funds. This testimony begins with a discussion of different aspects of this question. But many investor protection issues reflect longstanding problems that have been left unattended by the SEC. There continue to be significant 

gaps in mutual fund fee disclosure rules, reform of fund distribution regulation is 

long overdue, and the SEC’s fund governance initiative seems to have been all but 

forgotten. The SEC continues to allow hedge funds to offer their shares to unsophisticated investors, and brokers continue to receive undisclosed selling compensation 

that creates an incentive to sell the most remunerative funds even if they are not 

the best funds for the client. 

On the whole, however, the investment management industry has fared well in 

the current crisis. Equity mutual funds have experienced their largest single year 

loss in history, yet net redemptions have remained small. Employee benefit plan 

participants generally have continued to make regular investors in funds. The mutual fund structure has been shown to be remarkably resilient in this time of stress. 

Investors seem to have faith in mutual funds’ promise to convert their accounts to 

cash in short order at their next computed NAV, which is based on actual market 

values as opposed to malleable accounting principles. More money has flowed out 

of broker-managed accounts than mutual funds. Only one money market fund has 

experienced a loss of principal (compared with the failure of dozens of banks), and, 

with the playing field with banks temporarily leveled by the Treasury’s temporary 

insurance program, money market funds have increased their total assets. The investment management industry’s success depends, however, on its and its regulators’ keeping pace with the needs of investors. 

MONEY MARKET FUNDS 

Money Market Fund Insurance 1

As discussed above, mutual funds have been a singular success story in the midst 

of the current financial crisis. Money market funds arguably have been the best illustration of this success. As often happens when those who succeed are surrounded 

by failed competitors, however, some have responded to the failure of a single retail 

money market fund—the first in history—by demanding that money market funds 

be converted to and regulated as banks. A former Fed chairman explained this position as follows: ‘‘If they are going to talk like a bank and squawk like a bank, they 

ought to be regulated like a bank.’’ The problem with this argument is that money 

markets do not fail like banks. 

Since 1980, more than 3,000 U.S. banks have failed, costing taxpayers hundreds 

of billions of dollars. During the same time period, two money market funds have 
105 

2 Ironically, money market funds to date have provided a net positive contribution to the ongoing bailout of financial institutions. The Treasury has collected more than $800 million in money 

market fund insurance premiums only a small fraction of which, if any, are likely ever to be 

paid out in claims. 

failed, costing taxpayers zero dollars. 2 The lesson that the Group of 30 takes from 

this history is that it is money market funds that should be regulated as banks. The 

lesson that Congress should take from this history is that banks should be regulated 

more like money market funds. As discussed further below, banks routinely fail because they are permitted to invest deposits that can be withdrawn at a moment’s 

notice in illiquid, long-term, risky assets. In comparison, money market funds invest 

in liquid, short-term, safe assets. The Group of 30 has disparaged money market 

funds as ‘‘underscor[ing] the dangers of institutions with no capital, no supervision, 

and no safety net,’’ yet the extraordinary stability of money market funds relative 

to banks makes a mockery of their argument. 

It is banks that should be regulated like money market funds, with the investment of insured bank deposits being limited to liquid, short-term, safe assets. There 

is no longer any good policy reason to insure bank deposits backed by longterm, 

risky assets. The current financial crisis has demonstrated that banks no longer 

play a special role in this market. Many types of entities now play a significant role 

in the creation of liquidity through investment in long-term assets that historically 

was dominated by banks. And many of these entities rely on shortterm liabilities 

(i.e., funds subject to payment on demand), including mutual funds, to fund such 

investments. Any regulatory regime that seeks to mitigate the systemic risk inherent in the investment of short-term funds in long-term ventures must consider the 

full spectrum liquidity-creation mechanisms and reject a bank-centric view of finance that distorts efficient investment and leaves unregulated large areas of financial activities. 

What should be insured is cash accounts on which the stability of the payments 

system depends. The current crisis has demonstrated the need to ensure that the 

cash management vehicles that form the foundation of our payments system are absolutely secure. Deposit insurance provides this security. Its weakness, however, is 

that it also insures risks that are necessary to the provision of transactional services. Banks are permitted to invest insured bank deposits in longterm risky ventures, thereby destabilizing the payments system and inflicting large losses on the 

insurance fund and taxpayers. Money market funds have been a paragon of stability 

because they are permitted to invest only in a diversified pool of short-term, highquality assets. 

The answer to whether money market fund insurance should be made permanent 

seems obvious. Terminating the temporary insurance program could lead to another 

run on money market funds and require that the program immediately be restored. 

Even if a run does not follow termination of the program, money market funds will 

continue to represent a major source of transactional services the failure of which 

would threaten the viability of our payments system. Money market fund shareholders know this. The question of whether there is an implied federal guarantee 

of money market funds has been answered. The next time that a run on money market funds seems imminent, a federal entity will have to stop the run with a guarantee, except that without an insurance program in place it will not have collected 

any premiums that (if risk-based) might have reduced risktaking and that would 

have provided non-taxpayer funds with which to cover losses. Taxpayers will be left 

to back up this guarantee. 

At the same time that federal insurance is extended to all significant sources of 

transaction accounts, it should be used to reduce exposure to risk from the investment of short-term deposits in long-term, risky assets. To some extent, this would 

be accomplished by making money market fund insurance permanent. The higher 

yields historically offered by money market funds would siphon even more deposits 

from banks reduce the attendant risk of their investment in risky assets. Federal 

insurance also should be extended to a new kind of bank that was required to invest 

deposits in the same kinds of assets as money market funds. In order to enable compete such ‘‘narrow banks’’ to compete effectively, they would be relieved of burdens 

unique to banks, such as the requirements of the Community Reinvestment Act. 

Narrow banks also would continued to have the advantage of access to the discount 

window. Without making any changes to existing deposit insurance coverage, extending coverage to money market funds and narrow banks would reduce the 

amount of deposits subject to long-term risk and the likelihood of failure. 
106 

Prudential Regulation 

Prudential regulation, as used herein, refers to government-imposed rules designed to ensure that adequate assets stand behind the liabilities of financial institutions. Prudential regulation is an inherently suboptimal approach to risk because 

free markets are far more efficient at pricing risk than governments. Governments 

cannot avoid injecting political considerations into the underwriting of risk, which 

results in inevitably inefficient risk-minimization structures. Nonetheless, shortterm social instability can cause permanent damage to social, political and commercial institutions. In some cases, government intervention is necessary to mitigate potentially destabilizing fluctuations in free markets. 

Under this admittedly oversimplified framework for government intervention in 

the capital markets, I would argue that our payments systems creates the kind of 

risk that should not be left to free market forces. The payments system refers to 

the network of providers of transactional services that enable a non-specie-based 

economic system of exchange to operate. The temporary collapse of our payments 

system could leave economic activity to be conducted on a strictly barter or specie 

basis until the payments system was restored. The difficulty with leaving the payments system to the mercy of free markets is that the social and political upheaval 

that might result from a temporary collapse of our payments system could turn the 

collapse into a long-term event with long-term political, social and economic consequences. On this basis, it is advisable to support the payments system with an 

unconditional government guarantee of cash accounts on which the payments is primarily based. Notwithstanding the likely inefficiencies of such an insurance regime, 

they are outweighed by the potential benefits of protecting the payments system. 

One purpose that deposit insurance serves is to guarantee bank deposits and 

thereby stabilize an important foundation for the payments system. There are two 

difficulties with deposit insurance, however. First, deposit insurance covers risks 

that are not necessarily attendant upon the operation of cash accounts. Cash accounts can serve as an important linchpin of the payments system without being 

invested in long-term, high-risk assets such as the types of assets in which banks 

typically invest deposits. Money market funds also provide an important linchpin 

on the payments system, and they do so without taking such risks. 

Second, deposit insurance is exclusive to bank deposits. It is not available to other 

types of cash accounts even if those accounts pose a similar systemic threat to the 

payments system. When a run on money market funds seemed imminent in late 

September 2008, there was no government guarantee to prevent the run from turning into a wholesale transfer of assets out of money market funds. With $4 trillion 

in assets, such a stampede could have shut down the payments system with potentially devastating long-term effects. The Treasury Department prudently installed 

a government guarantee and halted the run. With temporary money market fund 

insurance in place, the vast majority of assets in transaction accounts are covered 

by a federal guarantee. 

Thus, insuring money market funds and narrow banks would promote appropriate 

prudential regulation that was designed to protect the stability of our payments system without transferring unnecessary risk to the government and taxpayers. 

Prudential Regulator 

The current financial crisis has exposed a persistent flaw in our regulatory structure. Prudential oversight should be provided through a regulatory structure that 

is amenable to the regulatory philosophy that prudential oversight entails. Prudential regulators are risk averse. Their purpose is to prevent loss. A regulator that 

is tasked with protecting investors and promoting free and efficient markets, on the 

other hand, will not be risk averse. The securities laws focus on full disclosure of 

material information is designed to promote and reward risk-taking based on the 

efficient flow of capital to its highest value use, even when some uses entail significant risk. Permitting such risk-taking is inimical to the essence of prudential regulation. 

In more concrete terms, the SEC’s roles: (1) in protecting investors and promoting 

free, efficient markets, and (2) as the prudential regulator of brokerdealers and 

money market funds, are in conflict. Similarly, banking regulators’ consumer protection role has always suffered in the shadow of its primary prudential regulator role. 

The SEC’s and banking regulators’ contradictory positions on fair value accounting 

reflect this conflict. The SEC favors accurate pricing that reflects market values; 

banking regulators favor pricing that will restore investor confidence. As a prudential regulator, the SEC’s failure to properly administer net capital rules has led to 

disappearance of the five largest investment banks as independent entities and its 

approach to money market funds has necessitated the intervention of a true prudential regulator, the Treasury Department, to stop a run on money market funds. Con-
107 

3Petition from Fund Democracy, Consumer Federation of America, Consumer Action, AFL– 

CIO, Financial Planning Association and National Association of Personal Financial Advisors, 

to Nancy Morris, Secretary, U.S. Securities and Exchange Commission (Jan. 16, 2008) available 

at http://www.funddemocracy.com/MMF%20Rulemaking%20Petition.pdf 

versely, banking regulators’ record of consumer protection has been abysmal, with 

their role more often undermining consumer protection than enhancing it. 

In short, the areas of financial activity that necessitate prudential regulation 

should be administered by a prudential regulator. Investor protection and free markets should be handled by a different regulator. Although I support the creation of 

a single prudential regulator in theory, I believe it would be more realistic to shift 

prudential regulation to existing banking regulators and to locate consumer protection responsibility with respect to financial products and services with the SEC or 

FTC. If prudential regulation for insurance companies were established at the federal level, a special prudential regulator may be needed. It is not clear that the 

unique characteristics of insurance liabilities would be good fit for a prudential regulator that was responsible for other types of financial products. Insurance products 

that have predominantly investment characteristics (e.g., equity-indexed annuities), 

however, should be regulated by the SEC as to sales practices and disclosure, and 

by the same federal prudential regulator that would be responsible for overseeing 

money market funds and banks. 

Electronic Filing of Portfolios 

In January 2008, my advocacy group, Fund Democracy, and the Consumer Federation of America, Consumer Action, AFL–CIO, Financial Planning Association and 

National Association of Personal Financial Advisors petitioned the SEC to adopt a 

rule requiring money market funds to file their portfolios electronically with the 

SEC. 3 The letter was motivated by our concern that the SEC’s ad hoc practice of 

allowing fund sponsors to bail out their money market funds before they broke a 

dollar was inadequate in a time of market turmoil. The letter proved to be, unfortunately, prescient. Within the year, a retail money market fund broke a dollar for 

the first time. 

Money market fund regulation, whether administered by the SEC or a true prudential regulator, should include an electronic, portfolio-filing requirement. Electronic filing would enable the regulator to monitor, among other things, the prices 

at which different money market funds are carrying the same securities. Although 

small pricing discrepancies would be inevitable and no cause for concern, large pricing discrepancies would indicate that some fund was underpricing or, more importantly, overpricing its shares. Moreover, filings would show the liquidity of the market for securities and thereby provide insight into the credibility of prevailing prices 

in more thinly traded issues. As stated by the SEC when it made a similar proposal 

1995, money market fund portfolio filing would enhance regulators’ ability: ‘‘to monitor money fund compliance with the federal securities laws, target its limited onsite 

examination resources, and respond in the event of a significant market event affecting money funds and their shareholders.’’ The SEC’s own justification for this 

proposal is far stronger today that it was twelve years ago. 

Sponsor Support 

The SEC has historically dealt with the risk of a money market fund’s breaking 

a dollar by granting no-action relief to fund sponsors to purchase the problem assets 

at par, pump cash into the fund, extend guarantees, or take other steps to restore 

the fund’s per share net asset value. This continues to be an appropriate tool for 

addressing the risk of money market fund failure, but it has become far too routine. 

The frequent granting of no-action relief for transactions that generally violate the 

affiliated transaction prohibitions of the Investment Company Act undermines the 

rule of law and encourages lax oversight by fund managers. 

First, the SEC should amend the rule that exempts certain of these transactions 

to cover a broader range of sponsor support mechanisms. Sponsors should then be 

expected to have established written procedures that address scenarios in which 

their funds may need support and the mechanisms that the fund expects to use to 

provide it, if any. 

Second, the sponsor’s rescue policy should be disclosed in its Statement of Additional Information (a fund filing that investors can obtain on request or on the 

SEC’s Web site). As indicated by Fitch’s recent announcement that it intends to revise its money market fund rating system to reflect sponsors’ rescue plans, these 

plans have become material aspects of a fund’s stability. Banking regulators have 

previously indicated that they might not permit a bank affiliate to bail out its 

money market fund. This risk also should be disclosed to investors. As discussed in 
108 

4 If money market fund insurance is made permanent, such sponsor support arrangements 

should be formalized and made mandatory. Sponsor support of money market funds is the functional equivalent of the equity buffer that insured banks are required to maintain under banking regulations. In this respect, it should be noted that claims that money market funds have 

no ‘‘capital’’ are misleading. Money market funds do have capital; it is the sponsor support that 

has, in dozens of instances prevented money market funds from breaking a dollar and resulted 

in a record of only two failures in almost 30 years. The problem is that the capital support is 

informal and voluntary. 5 I am aware of two cases that the Commission has brought under Section 36(b), neither of 

which involved an excessive fees claim. See In the Matter of American Birthright Trust Management Company, Inc., Litigation Rel. No. 9266, 1980 SEC LEXIS 26 (Dec. 30, 1980); SEC v. 

Fundpack, Inc., No. 79-859, 1979 WL 1238 (D.D.C., Aug. 10, 1979). 

the consumer groups’ January 2008 letter, the 11th hour negotiation of the terms 

of sponsor support between sponsors and SEC staff behind closed doors should not 

be the model by which the SEC and the fund industry manage unexpected market 

events. 41

Liquidation Procedures 

The haphazard liquidation of certain Reserve Funds has exposed a significant gap 

in the regulatory structure for money market funds. The complete liquidation of any 

mutual fund, even a highly liquid money market fund, cannot be accomplished overnight, but there should be no delay in the distribution of some percentage of a 

money market fund’s assets in short order. Money market fund shareholders use 

these funds as the functional equivalent of bank accounts on which they often rely 

for daily living expenses. The SEC should require that money market fund compliance manuals include procedures that set forth the manner in which immediate redemptions can be effected in the event that circumstances cause the suspension of 

regular distributions. The FDIC generally is able to ensure that insured depositors 

receive a substantial part of their funds almost immediately following the closure 

of an insured bank. While it is reasonable for some money market fund assets to 

be withheld pending a final resolution by a receiver, there is no excuse for not releasing some percentage of shareholders’ accounts in short order. 

Liquidity Oversight 

Many of the problems underlying the current crisis result from a failure to incorporate liquidity risk into prudential regulation. Although money market funds 

present less liquidity risk because of the short maturity, high quality and diversification of their assets, Rule 2a-7 should require that money market fund directors 

specifically consider the liquidity risk posed by the fund’s portfolio. Fund directors 

should be required to ensure that procedures have been adopted and implemented 

that are reasonably designed to ensure that the pricing of portfolio securities has 

been tested against various market failure scenarios. 

MUTUAL FUNDS 

Excessive Fees 

Section 36(b) of the Investment Company Act, which was passed in 1970, provides 

that a fund director and fund manager shall have a fiduciary duty with respect to 

the fees charged by the fund, and tasks the Commission with bringing actions 

against directors and fund managers who violate this duty. The Commission has 

never brought a case for excessive fees. 5 No plaintiff has ever prevailed in litigated 

claim under this provision although there have been some significant settlements. 

Recent developments have made it unlikely that a section 36(b) claim will ever 

survive a motion to dismiss. Defense experts often have argued that mutual fund 

fees are set in a competitive marketplace and therefore are necessarily fair under 

section 36(b). In a Seventh Circuit decision, Judge Easterbrook adopted this theory, 

thereby effectively repealing the Act’s private cause of action. In a split en banc 

opinion, Judge Posner rejected Judge Easterbrook’s analysis, arguing that markets 

are not always efficient. The same Seventh Circuit also recently ruled that an Erisa 

fiduciary has no duty when selecting investments for a 401(k) plan not to choose 

funds that charge excessive fees. The court granted defendants’ motion to dismiss 

even after accepting as true, among other things, plaintiffs’ allegation that the plan 

sponsor had lied to plan beneficiaries about absorbing all of the costs of administering the plan (beneficiaries actually paid part of the costs). The Department of 

Labor filed an amicus brief opposing the defendants’ position in that case. 

The Supreme Court has granted certiorari in the Seventh Circuit’s 36(b) case. Unfortunately, the Court has been quite hostile to private claims under the federal securities. I support many of the statutory limits on private claims that Congress has 

enacted over the last 15 years, as well as some of the interpretive restrictions im-
109 

6 A number of years ago, my research assistant was able to identify 18 funds in Morningstar’s 

database with expense ratios in excess of 5 percent, yet the average management fee for the 

same funds was only 1.06 percent, and only one fund’s management fee exceeded 1.29 percent. 7Shareholder Reports and Quarterly Portfolio Disclosure of Registered Management Investment Companies, Investment Company Act Release No. 25870, Part I.B (Dec. 18, 2002). 8 Id. (citing a joint report of the Commission and the Office of the Comptroller of the Currency 

that ‘‘found that fewer than one in five fund investors could give any estimate of expenses for 

their largest mutual fund and fewer than one in six fund investors understood that higher expenses can lead to lower returns’’). 9See Fiduciary Requirements for Disclosure in Participant-Directed Individual Account Plans, 

Employee Benefits Security Administration, U.S. Department of Labor, 73 F.R. 43014, n.13 

(July 23, 2008) (‘‘DoL Proposal’’). 

posed by the Court. But some decisions have gone too far and/or created absurd results. There is significant risk that the Court’s decision will result in a complete 

evisceration of section 36(b). This will leave mutual fund investors at the mercy of 

opaque fee disclosure and no private claim against fund managers that charge excessive fees. It is therefore imperative that Congress strengthen the fiduciary duty 

standard under section 36(b) and implement long-overdue reforms in fee disclosure 

requirements. 

Fiduciary Duty Standard 

Section 36(b) applies a fiduciary duty to directors only with respect to fees paid 

to the fund manager. When a fund’s excessive fees are attributable not to fees paid 

to the fund manager, but to fees paid on account of the administrative expense of 

operating a small fund, this fiduciary duty is not triggered. Thus, a fund director’s 

decision to offer a fund with an 8 percent or 10 percent expense ratio may be reviewable only under the toothless state law standard that section 36(b) was designed to supplement. 6

Congress should enact legislation that creates a fiduciary duty for fund directors 

that would require, for example, that directors affirmatively find that the fund could 

be a reasonable investment in light of its investment objective, performance history 

and expenses. If a fund’s fees were so high so as to render the investment irrational, 

the directors would have to take action to cure the problem, such as by merging the 

fund into another fund with lower fees. 

Fee Disclosure 

As the Commission has recognized, fund fees ‘‘can have a dramatic effect on an 

investor’s return. A 1 percent annual fee, for example, will reduce an ending account 

balance by 18 percent on an investment held for 20 years.’’ 7 Notwithstanding the 

importance of fees, ‘‘the degree to which investors understand mutual fund fees and 

expenses remains a significant source of concern.’’ 8 The Department of Labor has 

found that employee benefit ‘‘plan participants on average pay fees that are higher 

than necessary by 11.3 basis points per year.’’ 9

In many respects, investors’ lack of understanding is directly attributable to the 

way in which fees are disclosed. The current expense ratio is misleading because 

it excludes what can be a fund’s single largest expense: portfolio transaction costs. 

12b-1 fees are misleading because they create the impression that funds that do not 

charge 12b-1 fees therefore do not incur distribution expenses. Fund fees are disclosed in dollars based on hypothetical amounts, rather than a shareholder’s actual 

costs, and the location of this disclosure makes it unlikely that investors will pay 

attention to this information. Nowhere are funds required to put their fees in context by comparing them to fees charged by index funds and comparable managed 

funds. The Commission has failed to support or actively opposed reforms designed 

to address each of these problems. 

Portfolio Transaction Costs: The current expense ratio, which to be accurate 

should be referred to as the ‘‘partial expense ratio,’’ excludes portfolio transaction 

costs. Portfolio transaction costs are the costs incurred by a fund when it trades its 

portfolio securities. Some portfolio transaction costs are easy to measure. For example, commissions paid by funds are disclosed as a dollar amount in the Statement 

of Additional Information, which is provided to shareholders only upon request. 

Other portfolio transaction costs must be measured indirectly, such as spread costs, 

but their existence and their substantial impact on fund expenses is no less certain. 

The Commission concedes that portfolio transaction costs constitute a significant 

expense for fund shareholders. ‘‘[F]or many funds, the amount of transaction costs 

incurred during a typical year is substantial. One study estimates that commissions 
110 

10 Request for Comments on Measures to Improve Disclosure of Mutual Fund Transaction 

Costs, Investment Company Act Rel. No. 26313, at Part I (Dec. 19, 2003) (‘‘Concept Release’’) 

(citing John M.R. Chalmers, Roger M. Edelen, Gregory B. Kadlec, Fund Returns and Trading 

Expenses: Evidence on the Value of Active Fund Management, at 10 (Aug. 30, 2001) (available 

at http://finance.wharton.upenn.edu/edelen/PDFs/MFltradexpenses.pdf). ‘‘These estimates 

omit the effect of market impact and opportunity costs, the magnitude of which may exceed commissions and spreads.’’ Id. 11See DoL Proposal, supra, at n.13. 12Memorandum from Paul F. Roye, Director, Division of Investment Management, Securities 

and Exchange Commission to William H. Donaldson, Chairman, Securities and Exchange Commission, at 28 and 30 (June 3, 2003) (available at http://financialservices.house.gov/media/ 

pdf/02-14-70%20memo.pdf) (‘‘Donaldson Memorandum’’). 13See Concept Release, supra. 14 Exhibit A also shows that, when commissions and spread are included, the expenses of the 

Strong Discovery Fund rise from 1.50 percent to 4.50 percent, the CGM Focus Fund from 1.20 

percent to 4.48 percent, and the RS Mid Cap Opportunities Fund from 1.47 percent to 7.52 percent. 

and spreads alone cost the average equity fund as much as 75 basis points.’’ 10 A 

2004 study commissioned by the Zero Alpha Group, a nationwide network of feeonly investment advisory firms, found that commissions and spread costs for large 

equity funds, the expenses and turnover of which are well below average, exceeded 

43 percent of the funds’ expense ratios. A 2004 survey by Lipper identified at least 

86 equity funds for which the total amount paid in commissions alone exceeded the 

fund’s total expense ratio, in some cases by more than 500 percent. The Department 

of Labor expressly cited, as a significant failing of the mutual fund expense ratio, 

its omission of portfolio transaction costs, which can equal many multiples of a 

fund’s other expenses. 11

Notwithstanding the significance of portfolio transaction costs, the Commission 

has opposed including these costs in the mutual fund expense ratio. In a June 9, 

2003, memorandum, the Commission demonstrated that it had already prejudged 

the issue of the disclosure of portfolio transaction costs. It concluded that ‘‘it would 

be inappropriate to account for commissions as a fund expense’’ and unequivocally 

answered the question of ‘‘whether it is currently feasible to quantify and record 

spreads, market impacts, and opportunity costs as a fund expense. We believe that 

the answer is ‘no.’ ’’ 12 Only after reaching this decision did the Commission proceed 

with the formality of issuing a concept release asking for comment on disclosure of 

portfolio transaction costs, apparently for the purpose of considering any alternative 

other than full inclusion in the expense ratio. 13 Six years later, the Commission has 

not taken any action on its proposal other than to include turnover ratios (an indirect and opaque reflection of portfolio transaction costs) with the fee table in new 

the summary prospectus. The expense ratio continues to be a partial expense ratio. 

The Commission’s position is flatly inconsistent with its responsibility to provide 

the information that the marketplace needs to promote price competition. By requiring funds to use the partial expense ratio, the Commission is effectively forcing the 

public to choose funds based on the Commission’s view of the proper measure of 

fund costs. The Commission’s decision to second-guess the market by deciding for 

investors which kinds of information they are capable of understanding contradicts 

basic market principles and is inconsistent with our capitalist system of free enterprise. 

Investors logically look to the Commission to provide standardized reporting of expenses, and it is appropriate for the Commission to provide this service. But once 

the Commission has provided the important service of providing standardized information, it should remove itself from the market-driven determination of which information provides the best measure of a fund’s true costs. 

The Commission has argued that including portfolio transaction costs might distort fund managers’ behavior. As noted above, this is not for the Commission to 

judge. The marketplace should decide which expense ratio—the partial expense 

ratio or a total expense that includes portfolio transaction costs—is the best measure of a fund’s costs. 

Furthermore, it is the partial expense ratio that distorts fund managers’ and investors’ behavior alike. The partial expense ratio distorts fund managers’ behavior 

by not holding them accountable for their decisions to spend a substantial amount 

of fund assets on trading securities. 

As illustrated in Exhibit A, for example, the Commission believes that investors 

should only be told that the expense ratio for the PBHG Large Cap Fund is 1.16 

percent, and that they should not be told that when commissions and spread costs 

are included, the Fund’s expense ratio for the period shown is 8.59 percent. 14 The 

true cost of that Fund is more than seven times the amount shown in the Commission’s expense ratio. How can it be in the best interests of investors or consistent 
111 

15The Lipper data show that at least 31 funds’ expense ratios would exceed 10 percent if they 

include commissions and spread costs. 16 Concept Release at Part III.A, supra. 17Donaldson Memorandum, supra, at 36. Regarding directed brokerage, the Commission recently stated: ‘‘We believe that the way brokerage has been used to pay for distribution involves 

unmanageable conflicts of interest that may harm funds and fund shareholders.’’ Prohibition on 

the Use of Brokerage Commissions to Finance Distribution, Investment Company Act Rel. No. 

26356 at Part II (Feb. 24, 2004). 18Government Accounting Office, Mutual Funds: Information On Trends In Fees and Their 

Related Disclosure (March 12, 2003). 19See DoL Proposal, supra. 

with free market economics to require, much less permit, the Fund to show its total 

costs of 1.16 percent? The partial expense ratio is misleading because it impliedly 

represents, in conjunction with other shareholder expenses listed in the fee table, 

the total cost of fund ownership. 

The data in Exhibit A does not reflect outliers, but randomly selected examples 

from funds with more than $100 million in assets. If smaller funds with high turnover were considered, the differentials would be so large as to render the Commission’s partial expense ratio fraudulent. For example, Lipper reports that the Rydex 

Telecom Fund’s commissions for the fiscal year ending March 31, 2003, equaled 8.04 

percent of assets. By applying the Zero Alpha Group study’s methodology of estimating spread costs, we can estimate that total spread costs during that period 

equaled 8.75 percent of assets. Thus, whereas the Commission tells us that the 

Rydex Telecom Fund’s is only 1.37 percent, its true costs are 18.16 percent, or 13 

times higher. 15 The Commission’s partial expense ratio distorts investors’ behavior 

because investors obviously would make different investment decisions if they knew 

the true costs of owning certain funds. 

The Commission’s partial expense ratio also distorts managers’ behavior because 

it creates an incentive for them to pay for non-execution expenses with fund commissions. Under current law, fund managers can payer higher commissions—that 

is, more than it would cost merely to execute the fund’s trades—in return for nonexecution services. By paying for these non-execution services with commissions, or 

what are known as soft dollars, fund managers effectively move these costs out of 

the expense ratio where they belong. This enables the fund that uses soft dollars 

to show a lower partial expense ratio than a fund that does not—even if the fund 

managers use identical services and have identical operating expenses. The Commission itself has conceded that ‘‘[t]he limited transparency of soft dollar commissions may provide incentives for managers to misuse soft dollar services.’’ 16

Furthermore, the nondisclosure of portfolio transaction costs exacerbates the conflict of interest that is inherent in the payment of soft dollars. As the Commission 

has recognized, 

[s]oft dollar arrangements create incentives for fund advisers to (i) direct 

fund brokerage based on the research provided to the adviser rather than 

the quality of execution provided to the fund, (ii) forego opportunities to recapture brokerage costs for the benefit of the fund, and (iii) cause the fund 

to overtrade its portfolio to fulfill the adviser’s soft dollar commitments to 

brokers. 17

The continued concealment of portfolio transaction costs permits the soft dollar 

conflict to operate virtually unchecked by market forces, whereas including portfolio 

transaction costs in a total expense ratio would, at least, permit the marketplace 

to judge the efficacy of soft dollar arrangements. If Congress does not take steps to 

eradicate soft dollars, at least it can require that these costs be disclosed so that 

the market can reach its own judgments regarding their efficacy. 

Dollar Disclosure of Fees: Under current disclosure rules, funds are not required 

to disclose to investors how much they pay in fees. Many other financial services 

documents show investors exactly how much they are paying the service provider, 

including bank statements, insurance bills, credit card statements, mortgage loans 

and a host of other documents. But mutual funds provide only an expense ratio (and 

a partial one, at that, see supra) and the dollar amount of a hypothetical account. 

Congress should require that funds provide individualized dollar disclosure of 

fund expenses in shareholder statements, as recommended by the Government Accounting Office 18 and proposed for employee benefit plans by the Department of 

Labor. 19 This requirement is necessary for two reasons. First, although the expense 

ratio is appropriate for providing comparability across different funds, it does not 

pack the same import as a dollar amount. Providing investors with the amount in 
112 

20 In 1999, Paul Haaga, Chairman of the Investment Company Institute and Executive Vice 

President of the Capital Research and Management Company, stated at an SEC roundtable: 

‘‘the idea that investors ought to prefer the funds that don’t tell what they’re spending on distribution over the ones that do is nonsense. You know, if you’re spending money on distribution, 

say it. If you’re not pending money on distribution don’t say it; but don’t pretend that there 

are no expenses there for a fund that doesn’t have a 12b-1 plan.’’ Conference on the Role of 

Investment Company Directors, Washington, D.C. (Feb. 23 & 24, 1999) (Haaga was not ICI 

Chairman at this time). 

dollars that they actually spent will give concrete form to an indefinite concept and 

make investors consider more fully the costs of different investment options. 

Second, placing the dollar amount of expenses in the shareholder statement will 

direct shareholders’ attention to the actual costs of fund ownership. No document 

is more likely to be read than a shareholder statement that shows the value of the 

shareholder’s account and transaction activity during the period. Whereas the prospectus and shareholder report typically go directly from the mailbox to the trash 

can, even the most uninformed investors normally open their statements to check 

on the status of their accounts. There is no better way to draw shareholders’ attention to the costs of investing than to require that the dollar amount of fees for the 

period be disclosed next to the value of the investor’s account. 

Some members of the fund industry have opposed informing investors about the 

actual costs of their fund investments on the grounds that doing so would be too 

costly and might mislead investors. It appears that MFS Investment Management, 

one of the largest mutual fund managers in America, disagrees. MFS offers to include actual dollar disclosure in investor statements, which undercuts industry arguments that providing this information is economically infeasible. The Department 

of Labor has proposed to require dollar disclosure of fees for plan participants and 

the Government Accountability has recommended that the SEC do the same. 

The Commission opposes disclosure of shareholders’ actual costs and opposes including dollar disclosure in shareholder statements. The Commission concluded its 

consideration of a proposal some years ago to require funds to disclose individualized costs in shareholder statements by expressly rejecting both concepts. Instead, 

the Commission decided to require disclosure of the hypothetical fees paid on a 

$1,000 account in the shareholder report, despite the facts that the hypothetical fees 

paid on a $10,000 account are already disclosed in the prospectus, and shareholders 

who most need to have their attention directed to the fees that they pay are least 

likely to read the shareholder report. In view of the Commission’s, express opposition to effective disclosure of actual fees paid by shareholders, shareholders will receive disclosure of their actual fees in shareholder statements only if Congress requires funds to provide that information. 

Fee Comparisons: Congress should take additional steps to promote price competition in the mutual fund industry by requiring that funds disclose fees charged by 

comparable funds and, for managed funds, the fees charged by index funds. Without 

any context, current fee disclosure provides no information about whether a fund’s 

fees are higher or lower than its peers. Current disclosure rules also do not show 

the premium paid to invest in a managed funds as opposed to an index fund. Requiring comparative information in the fee table would enable investors to consider 

a fund’s fees in context and evaluate how they compare to fees across the industry. 

Distribution Fees: The Commission currently requires that 12b-1 fees be disclosed 

on a separate line that describes those fees as ‘‘distribution fees.’’ It does not require 

that the fee table show the amount spent on distribution by the fund manager out 

of its management fee. This is inherently misleading, as investors often use the 

presence of 12b-1 fees as a negative screen that they use to avoid paying any distribution fees. In fact, investors in non-12b-1 fee funds may actually pay as much 

or more in distribution expenses than some investors in 12b-1 fee funds. 20

Congress should overrule the Commission’s position and require that, if distribution fees are stated separately in the fee table, they must reflect all distribution expenses paid by a fund, directly or indirectly. Alternatively, Congress should require 

that fund expenses be displayed in a pie chart that shows how much of a fund’s 

fees were spent on each type of service. The Commission’s current fee table is misleading and understates the amount of fund assets spent on distribution. 

Disclosure of Brokers’ Compensation: For virtually all securities transactions other 

than purchases of mutual fund shares, investors receive a transaction confirmation 

that shows how much the broker was paid in connection with the transaction. Permitting brokers to hide their compensation on the sale of mutual funds has spawned 

a Byzantine and harmful array of selling arrangements, including revenue sharing 

(also known as payments for shelf space), directed brokerage, and non-cash compensation. Mutual fund shareholders should be entitled to receive the same informa-
113 

21 Confirmation Requirements and Point of Sale Disclosure Requirements for Transactions in 

Certain Mutual Funds and Other Securities, and Other Confirmation Requirement Amendments, and Amendments to the Registration Form for Mutual Funds, Investment Company Act 

Rel. No. 26341 (Jan. 29, 2004). 22See Donaldson Memorandum, supra, at 70-71 (‘‘When a fund bears its own distribution expenses, the fund’s investment adviser is spared the cost of bearing those expenses itself, and 

the adviser benefits further if the fund’s distribution expenditures result in an increase in the 

fund’s assets and a concomitant increase in the advisory fees received by the adviser.’’). 

tion as other investors in securities in the form of full disclosure of their brokers’ 

compensation on fund transaction confirmations. Such disclosure also should show 

how breakpoints applied to the transaction, as well as any special compensation received by brokers for selling particular funds. 

Brokers also should be required to provide, at or before the time the investor 

places the order, an estimate of compensation to be received by the broker in connection with the transaction and the total costs of investing in the fund. When buying a house, purchasers are provided with an estimate of their total closing costs 

before making a final decision. As discussed immediately above, however, fund 

shareholders do not even receive a final statement of their actual costs, much less 

an up-front estimate of such costs. 

In January 2004, the Commission proposed to require brokers to provide, both at 

the point-of-sale and in the transaction confirmation, disclosure of the costs and conflicts of interest that arise from the distribution of mutual fund shares. 21 More than 

5 years later, the Commission has failed to take final action on its proposal. Congress should require that the SEC take final action on disclosure requirements that 

will result in brokers’ customers receiving disclosure of the broker’s economic incentives in the transaction. 

Distribution Arrangements 

12b-1 Fees 

When Congress enacted the Investment Company Act of 1940, it expressly prohibited fund managers from using fund assets to finance the distribution of the fund’s 

shares. Section 12(b) of the Act recognized the inherent conflict of interest between 

the manager’s desire to increase fund assets in order to increase its fees on the one 

hand, and the fund’s desire to hold down costs on the other hand. Unfortunately, 

the policy underlying Section 12(b) has long been abandoned, as fund assets are 

used for a wide range of distribution expenses that benefit fund managers at the 

expense of fund shareholders. 

The policy of separating the product from its distribution was first abandoned by 

the Commission when, after a prolonged review, it adopted Rule 12b-1 in 1980. In 

the 1970s, mutual funds experienced periods of net redemptions that prompted fund 

managers to lobby the Commission to permit the use of fund assets to finance the 

distribution of the funds’ shares. Fund managers argued that net redemptions resulted in increased costs and that the financing of distribution by the fund would 

help reduce or eliminate net redemptions. 

The Commission initially rejected these arguments, but ultimately relented, provided that certain conditions were observed. For example, the Commission required 

that the fund’s independent directors approve the 12b-1 plan. Among the factors 

that the Commission said a fund’s directors should consider when evaluating whether to adopt or renew a 12b-1 plan was the plan’s effectiveness in remedying the 

problem that it was designed to address, i.e., increased costs resulting from net redemptions. 

The Commission’s most significant concern regarding 12b-1 fees was the conflict 

of interest that they created between the fund and its adviser. The Commission 

feared that 12b-1 fees would result in higher advisory fees and the fund’s adviser 

would not share the benefits of asset growth. 22 Some would argue that this is precisely what has happened, with any growth-based economies of scale realized from 

12b-1 fees being pocketed by fund managers and not shared with fund shareholders. 

Of course, this analysis goes primarily to the use of 12b-1 fees for marketing the 

fund, which is what Rule 12b-1 was intended to permit. It does not address the 

ways in which 12b-1 are actually used today and that were wholly unanticipated 

by the Commission when Rule 12b-1 was adopted. According to and Investment 

Company Institute report, only 5 percent of 12b-1 fees are spent on advertising and 
114 

23 Use of Rule 12b-1 Fees by Mutual Funds in 1999, Investment Company Institute, 9 Fundamentals 2 (April 2000). Funds spend the other 32 percent of 12b-1 fees on administrative 

services. Id. 24See Laura Johannes and John Hechinger, Conflicting Interests: Why a Brokerage Giant 

Pushes Some Mediocre Mutual Funds, Wall St. J. (Jan. 9, 2004); see also In the Matter of Morgan Stanley DW Inc., Exchange Act Rel. No. 48789 (Nov. 17, 2003). 25See Complaint, Benzon v. Morgan Stanley, No. 03-03-0159 (M.D. Tenn.). The SEC has 

banned the use of brokerage as compensation for fund brokerage. 

sales promotion, whereas 63 percent of 12b-1 fees are spent on broker compensation. 23

The use of fund assets to compensate brokers is precisely what Section 12(b) was 

intended to prohibit. This practice puts the fund squarely in the position of underwriting its own securities. The fund’s assets are used to incentivize brokers to recommend the fund over competing funds. The lesser the quality of the fund, the 

greater the pressure on the fund and its manager to pay brokers more to sell the 

fund. 

This irreconcilable conflict is mirrored on the distribution side of the business. 

When brokers are paid by the funds, rather than their customers, they have an incentive to recommend the fund that offers the biggest payout, rather than the fund 

that will provide the best investment for their customers. 24 There is another incentive for brokers to favor arrangements whereby they are compensated by funds, and 

that is the fact that the compensation from the fund is not transparent. Whereas 

the payment of a front-end load is relatively evident to the investor, the payment 

of a 12b-1 fee is not. It is even less clear that the already opaque 12b-1 fee is ending 

up in the broker’s pocket. For this reason, brokers and investors have begun to favor 

classes of fund shares where the broker is compensated by the fund, regardless of 

whether that class is in the best interests of shareholders. 25

Thus, the Commission has created a distribution compensation structure that is 

directly at odds with the interests of investors and the Investment Company Act. 

Rather than tying brokers’ compensation to their relationships with their customers, 

where the Investment Company Act requires that it be placed, the Commission has 

tied brokers’ compensation to their relationships with the funds, where the Investment Company Act expressly forbade its placement. 

Congress should reaffirm the supremacy of Section 12(b) and prohibit funds from 

compensating brokers for selling fund shares. Although this will necessarily entail 

the repeal of Rule 12b-1, it will in no way limit the ways in which investors can 

choose to pay their brokers. It will simply require that however brokers are compensated—through a front-end load, back-end load, level-load, or any combination 

thereof—they are compensated by their customers, not by the funds. Thus, if a customer chooses to pay his broker on an installment basis, at 0.50 percent each year, 

for example, that amount would be paid by the customer directly or deducted from 

his fund account. 

One might argue that, to maintain perfect legislative coherence, Congress should 

also prohibit fund managers from paying for general marketing services that are not 

connected to specific sales. I disagree. The conflict is substantially reduced in this 

situation because the fund manager’s and the fund’s interests are generally aligned. 

General marketing payments do not create a direct incentive for brokers to favor 

one fund group over another. General marketing does what advertising for decades 

has been shown to do: promote competition. Indeed, by locating these payments in 

the management fee, the manager will be spending its own money and accordingly 

will have an incentive to minimize costs. With an express requirement that independent fund directors evaluate the efficacy of fund manager expenditures on marketing and determine that resulting economies have been shared with fund shareholders, expressly permitting fund managers to use the management fee to pay for 

marketing would be appropriate. 

Revenue Sharing 

Over the last two decades, a compensation practice has evolved that strikes at the 

heart of the principle of full disclosure of conflicts of interest. Known as ‘‘revenue 

sharing,’’ this practice involves the payment of a part of fees collected by a mutual 

fund manager to a third party in return for administrative and/or distribution services. Notwithstanding the somewhat pejorative term ‘‘revenue sharing,’’ there is 

nothing necessarily inappropriate about the practice itself. Broadside critiques of 

revenue sharing are off base. Revenue sharing primarily reflects a compensation 

structure that can be a more efficient method of compensation than direct charges 

by each service provider to the client. Indeed, 12b-1 fees are functionally a kind of 

revenue sharing that are subject to enhanced (but still inadequate, see supra) disclosure requirements. 
115 

That being said, the regulation and practice of revenue sharing disclosure has 

been abysmal. Revenue sharing payments are generally included in the total fees 

charged by a fund. Unlike 12b-1 fees, they are not, and are not required to be, broken out separately in the mutual fund fee table. More importantly, they are not necessarily disclosed by the service provider that receives them. Revenue sharing constitutes compensation to service provider that is not part of the fees charged directly 

to the client, so the client often is unaware of the service provider’s economic incentive to sell the fund. When a broker recommends funds to clients, the broker does 

not disclose, and has not been required to disclose by the SEC or FINRA, that the 

broker will receive different amounts of revenue sharing payments depending on the 

fund purchased. The revenue sharing payments are made under the table; this blatant conflict of interest goes undisclosed. 

This is a significant problem in the context of brokers’ mutual fund sales. The 

SEC and FINRA continue to defend a suitability standard for brokers that does not 

require full disclosure of conflicts of interest, even when the broker is providing individualized investment advice to the client (as opposed to acting solely as a salesperson). This means that brokers can recommend funds that are ‘‘suitable’’ without 

disclosing that they are receiving higher revenue sharing payments from that fund’s 

manager than they would receive from the manager of a more suitable fund. The 

fees are not trivial. One SEC settlement involving revenue sharing payments revealed that brokers were receiving payments equal to 25 percent of the fund advisory fee in revenue sharing payments on every sale of that fund’s shares. It is inexcusable that brokers are not required to disclose this payment differential to their 

clients. 

Unlike brokers subject only to a suitability standard, fiduciaries generally have 

been required to disclose revenue sharing to their clients. In SEC v. Capital Gains 

Research Bureau, the Supreme Court held that that an investment adviser, as a fiduciary, was required to disclose all material conflicts of interest to clients. Courts 

have generally applied this principle to the disclosure of revenue sharing payments 

on the ground that this information would be of importance to advisory clients. The 

Seventh Circuit recently held, however, that an Erisa fiduciary has no obligation to 

disclose revenue sharing payments to beneficiaries as long as the total fees being 

paid are disclosed. This is a truly remarkable position, especially in the wake of recent legislation that permits conflicted persons to provide investment advice to 

401(k) plan participants on the condition that their compensation be the same regardless of the investment option selected. In other words, while Congress has been 

addressing the conflicted advice problem by flatly prohibiting differential compensation, the Seventh Circuit has decided not only that differential compensation can be 

received by an Erisa fiduciary, it does not even need to be disclosed. 

Both the SEC and FINRA have proposed rules that, depending on their final 

form, would require the disclosure of differential compensation. These rules, like 

many important investment management initiatives, have been pending for years. 

While the SEC has been paralyzed with indecision, state attorneys general have 

sued fund managers and brokers for their failure to disclose revenue sharing arrangements in their prospectuses and to their clients. The SEC’s failure to take a 

position one way or the other has created an unpredictable patchwork of regulation 

that benefits no one, especially not those who appropriately use revenue sharing in 

their compensation structures. And the SEC’s failure to require the disclosure of 

revenue sharing payments has allowed the practice to flourish. 

Congress should not continue to wait for regulators to recognize the obvious policy 

imperative of requiring full disclosure of conflicts of interest to financial services clients. In the last six years, a number of bills have been proposed that would, in one 

form or another, require the disclosure of revenue sharing and other forms of differential compensation. Congress should act promptly to enact some form of this legislation. The committee reports should make it clear that payments that create potential conflicts of interest must be disclosed and that the legislation is intended to 

overrule the Seventh Circuit’s Deere decision. 

Misleading Fund Share Classes 

Mutual funds often offer several classes of shares that reflect different ways of 

paying for distribution services. Typically, Class A shares carry a front-end load, 

Class B shares a back-end load, and Class C shares carry a level load. An investor 

is usually better off buying Class A shares if he intends to hold his shares for the 

longterm, and Class C shares if he may sell in the short-term. When Class B shares 

are best option, it is for the shareholder who holds for the mid-term. In some cases, 

however, there is virtually no shareholder for whom Class B shares are the best option. 
116 

26See Benzon v. Morgan Stanley, 2004 WL 62747 (M.D. Tenn.). 27 Amendments to Investment Company Advertising Rules, Investment Company Rel. No. 

26195 (Sep. 29, 2003). 

The Commission does not prohibit funds from offering Class B shares, even when 

there is no shareholder for whom Class B shares could be the best investment option. The Commission even rejected a rule amendment that would have required 

that funds illustrate in the prospectus the relative costs of each class of shares. Following the Commission’s lead, a federal court held in January 2004 that, even assuming that there was no rational investor for whom Class B shares would be the 

best investment, the fund had no duty to disclose this fact in the prospectus. 26

It is unconscionable that under current Commission positions a fund can offer a 

class of shares that would not be the best investment for any rational investor. Congress should require that multi-class funds illustrate, in a graphic format, the costs 

of investing in different classes over a 15-year period. In addition, Congress should 

require that the fund’s independent directors find, subject to a fiduciary duty as described above, that each class of shares offered could be a reasonable investment 

alternative. 

Fund Advertising 

Throughout the late 1990s, the Commission frequently berated the fund industry 

for misleading investors by advertising short-term performance. Funds with short 

life-spans routinely advertised one-year, sometimes even 2- and 3-year annualized 

investment returns in excess of 100 percent. With the crash of the stock bubble in 

2000, the Commission’s concerns were validated, as many of these funds experienced huge losses, in some cases in excess of 70 percent of their value. 

The Commission’s actions have not reflected its words, however. In September 

2003, the Commission adopted advertising rules that utterly failed to address the 

very problems that it had identified in the late 1990s. 27 The rules require funds 

to provide a telephone number or web address where current performance information is available, as if the problem with short-term performance was that it wasn’t 

current enough. The Commission also required that the text in fund ads include the 

statement that ‘‘current performance may be higher or lower than the performance 

data quoted.’’ 

Fund advertisements posted following market declines in 2000–2002 demonstrate 

the inadequacy of the Commission’s new rules. After three years of negative returns, 

stock funds had a banner year in 2003. Many of those funds are now advertising 

their stellar one-year performance without any disclosure of their poor returns in 

2000, 2001, and 2002. Because they are required only to show their one-, five- and 

ten-year returns, the negative returns of 2000 to 2002 are hidden from view. The 

ads create a misleading impression by showing the outsized returns of 2003 without 

any mitigating disclosure of the down years that preceded them and the performance volatility that those years’ returns illustrate. 

For example, one ad shows SEC-mandated performance for four funds, each of 

which experienced superior returns in 2003, but experienced losses or substantially 

lower performance in each year from 2000 to 2002. As illustrated in the table below, 

the disclosure of each fund’s annual performance in the years preceding 2003 would 

have presented a very different, far more accurate picture. The Commission’s rulemaking has done nothing to prevent such misleading ads, which have appeared routinely in business and personal finance magazines in the first few months of this 

year. 

Funds 

Disclosed* Not Disclosed** 

2003 2002 2001 2000 

Fund #1 ........................................... 51.68% (21.27%) (7.56%) (18.10%) 

Fund #2 ........................................... 42.38% (9.37%) (12.99%) (8.96%) 

Fund #3 ........................................... 23.36% (20.44%) (3.74%) 12.25% 

Fund #4 ........................................... 29.96% (17.16%) (5.02%) 8.54% 

* Source: Business 2.0 (March 2004). 

** Source: Fund Prospectuses. 

The Commission’s rulemaking also did nothing to address the problem of the disconnect between the advertised performance of funds and the actual returns experienced by shareholders. As confirmed by a recent DALBAR study, ‘‘[i]nvestment re-
117 

28DALBAR, Quantitative Analysis of Investor Behavior at 2 (2003). 29 Notably, the Commission requires that the prospectus include a bar chart that shows a 

fund’s return for each of the preceding ten years. If such a disclosure is necessary to make the 

prospectus not misleading, it is unclear why the same reasoning is not applicable in the context 

of a fund advertisement. 30Proposed Amendments to Investment Company Advertising Rules, Investment Company 

Rel. No. 25575, Part II.C (May 17, 2002). 31 Amendments to Investment Company Advertising Rules, supra. 32See Disclosure of Mutual Fund Expense Ratios in Performance Advertising, National Association of Securities Dealers (Jan. 23, 2004). 33 Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and 

Mutual Funds, Securities and Exchange Commission, at text accompanying note 1 (Sep. 22, 

1998). 34Testimony of Harold Bradley, Senior Vice President, American Century Investment Management, before the Subcommittee on Capital Markets, Insurance and Government Sponsored 

Enterprises, Committee on Financial Services, U.S. House of Representatives, at 5 (Mar. 12, 

2003). 

turn is far more dependent on investment behavior than on fund performance.’’ 28

DALBAR found that the average equity fund investor earned 2.57 percent annually 

over the last 19 years, in comparison with the S&P 500’s 12.22 percent annual return during the same period. This translates into a cumulative return for the S&P 

500 of 793.34 percent from 1984 to 2002, compared with equity fund investors’ actual cumulative return of 62.11 percent during the same period. 

These stunning and disheartening data illustrate, in part, a failure of investor 

education and individual choice. Investors have consistently chased the best performing funds just before they crashed, and dumped the worst performing funds just 

before they recovered. This sell-high, buy-low mentality is only encouraged by the 

Commission’s current approach to fund performance advertising, which permits 

funds to present outsized returns with no meaningful caveats regarding their volatility and the likelihood that performance will soon revert to the mean. 29

Not only do current rules fail to require meaningful disclosure about the volatility 

of fund returns, but they also fail to place outsized, one-year returns in the context 

of the market as a whole. To illustrate, the performance of the S&P 500 for 2003 

was 28.68 percent, which puts the 51.68 percent return of the Fund cited above in 

a light very different (albeit still positive) from one in which the performance data 

stands alone. The Fund’s advertised ten-year return of 10.58 percent would tell a 

different story if it were required to be juxtaposed against the S&P 500’s 11.07 percent ten-year return. 

The Commission also has recognized the need for investment returns to be considered in the context of fees, yet its rules do virtually nothing to benefit investors in 

this respect. In its proposing release, the Commission promised that its new rule 

would ‘‘ensure that fund advertisements remind fund shareholders about the availability of information about fund charges and expenses.’’ 30 Yet the final rule required only that fund advertisements refer investors to the prospectus for consideration of fund expenses, among other things. 31 In contrast, the NASD has proposed 

that fund advertisements include a box that shows both the fund’s maximum sales 

charge and its expense ratio. 32

Congress should require that fund advertisements include all information necessary to make the information presented not misleading. This must include, at a 

minimum, investment returns for each individual year where such returns differ 

materially from fund’s one-year performance, disclosure of the fund’s total expense 

ratio (i.e., including the fund’s portfolio transaction costs) and sales charges, and the 

performance and expenses of a comparable index fund. 

Soft Dollars 

The term ‘‘soft dollars’’ generally refers to brokerage commissions that pay for 

both execution and research services. The use of soft dollars is widespread among 

investment advisers. For example, total third-party research purchased with soft 

dollars alone is estimated to have exceeded $1 billion in 1998. 33 An executive with 

American Century Investment Management has testified that the research component of soft dollar commissions costs six times the value of the execution component. 34

Soft dollar arrangements raise multiple policy concerns. The payment of soft dollars by mutual funds creates a significant conflict of interest for fund advisers. Soft 

dollars pay for research that fund advisers would otherwise have to pay for them-
118 

35 Id. at 2 (the statutory safe harbor permitting soft dollars arrangements ‘‘encourages investment managers to use commissions paid by investors as a source of unreported income to pay 

unreported expenses of the manager’’). 36See Investment Company Act Section 17(e); Inspection Report at 38, supra. 37Donaldson Memorandum at 13-17, supra. Fidelity recently recommended that the Commission reconsider its decision not to require the quantification of soft dollar costs. Ann Davis, Fidelity Wants Trading Costs To Be Broken Down, Wall Street Journal (Mar. 15, 2004). 38 Inspection Report on the Soft Dollar Practices of Broker-Dealers, Investment Advisers and 

Mutual Funds, Securities and Exchange Commission, at text accompanying note 1 (Sep. 22, 

1998) (‘‘Section 28(e) Report’’). 39 Id. at Section V.C.4. 40 Commission Guidance on the Scope of Section 28(e) of the Exchange Act, Exchange Act Rel. 

No. 45194 (Dec. 27, 2001). 41 Investment Advisers Act Release No. 1469 (February 14, 1995). 42 Id. (quoting John Hill). 

selves. Advisers therefore have an incentive to cause their fund to engage in trades 

solely to increase soft dollar benefits. 35

Soft dollar arrangements normally would be prohibited by the Investment Company Act because they involve a prohibited transaction between the fund and its adviser. 36 Section 28(e) of the Securities Exchange Act, however, provides a safe harbor from the Investment Company Act for soft dollar arrangements as long as the 

brokerage and research services received are reasonable in relation to the amount 

of the commissions paid. 

The conflicts of interest inherent in soft dollar arrangements are exacerbated by 

current disclosure rules. The amount of fund assets spent on soft dollars is not publicly disclosed to shareholders, so they are unable to evaluate the extent, and potential cost, of the adviser’s conflict. 

Current disclosure rules reward advisers for using soft dollars because this practice creates the appearance that a fund is less expensive. The expense ratio does 

not include commissions, which gives advisers an incentive to pay for services with 

soft dollars, thereby enabling them to lower their management fees and the fund’s 

expense ratio. Advisers can effectively reduce their expense ratios by spending more 

on soft dollars, while the fund’s actual net expenses remain unchanged. 

Finally, current disclosure rules may encourage excessive spending on soft dollars. 

Advisers would tend to spend less on soft dollars if they knew that they would be 

held publicly accountable for their expenditures. 

The Commission has frequently recognized but declined to address the problem 

of soft dollars. As discussed above, the Commission is opposed to including portfolio 

transaction costs in funds’ expense ratios, which would have the benefit of enabling 

the market to determine for itself the efficacy of soft dollar arrangements. The Commission previously proposed a rule that would require that soft dollars costs be 

quantified, but decided against adopting it. 37 When the Commission staff last evaluated soft dollar arrangements in 1998, it concluded that additional guidance was 

needed in a number of areas. 38 For example, the staff found that many advisers 

were treating basic computer hardware—and even the electrical power needed to 

run it—as research services qualifying under the Section 28(e) safe harbor. 39 The 

staff recommended that the Commission issue interpretive guidance on these and 

other questionable uses of soft dollars, but it has failed to do so. 

In fact, the only formal action that the Commission has taken in recent years is 

to expand the use of soft dollars. In December 2001, the Commission took the position that the safe harbor should apply to markups and markdowns in principal 

transactions, although Section 28(e) expressly applies only to ‘‘commissions.’’ 40 This 

position directly contradicts not only the plain text of the statute, but also the position taken by the Commission in 1995 that section 28(e) ‘‘does not encompass soft 

dollar arrangements under which research services are acquired as a result of principal transactions.’’ 41 Although the Commission has, once again, suggested that intends to narrow the scope of soft dollars, its recent history suggests that Congressional action is necessary. In any case, the Commission lacks the authority to ban 

soft dollars. 

There is no better evidence that the time has come to ban soft dollars than the 

recognition of the insidious nature of this practice by members of the fund industry. 

In addressing the fact that soft dollars enable fund managers to use the fund’s 

money to pay for research used by the manager, the independent chairman of the 

Putnam Funds has stated that ‘‘[t]he best decisions get made when you buy services 

with your own money.’’ 42 Similarly, MFS’ chairman, Robert Pozen, 

sees the soft-dollar funnel as a lucrative one for brokers, but one that hides 

the true cost of such services to shareholders. ‘‘It’s all camouflaged,’’ said 
119 

43 Id. 44Landon Thomas, Jr., Mutual Fund Tells Wall Street It Wants & la Carte Commissions, New 

York Times (Mar. 16, 2004). 45MFS Ends ‘Soft Dollar’ System, supra. 46Fidelity Wants Trading Costs To Be Broken Down, supra. 47Tom Laurcella, For Retirement, ‘One Size’ Isn’t Always a Good Fit, Wall. St. J. (Mar. 2, 

2009) available at http://online.wsj.com/article/SB123549381087960625.html (‘‘A typical fund 

for an investor aiming to retire 20 years from now might have at least 80 percent in stocks. 

By the time the retirement date approaches, most funds typically have less than 40 percent in 

stocks.’’). 

Mr. Pozen, a former associate general counsel of the SEC. Now, he added, 

‘‘If we want something, if we think it’s valuable, we will pay cash.’’ 43

A Fidelity executive has acknowledged the pro-competitive advantage of a ban on 

soft dollars, stating: ‘‘[w]e don’t rule out a competitive environment through which 

all research is acquired through cash rather than commissions.’’ 44

The difficulty for fund firms, however, is that without a statutory ban on soft dollars they may suffer a competitive disadvantage MFS has estimated that paying for 

its own research will reduce its advisory fees. 45 Fidelity has estimated that of the $1.1 billion in commission it paid in 2003, $275 million paid for soft dollar research. 46 It is unrealistic to expect these fund managers to maintain the high road 

at the expense of reduced advisory fees, while other fund managers continue to pay 

their own research expenses through soft dollars rather than out of their own pockets. 

Fund Names and Investor Expectations 

The recent collapse of the stock market has exposed a significant gap in the regulation of mutual fund names. The average investor will reasonably assume that 

funds will invest consistent with their names, but mutual fund rules do not require 

that funds honor these expectations. 

To illustrate, one would expect a Target Date 2010 Fund to be designed to fit the 

needs of someone who planned to retire at age 65 in 2010. Such a fund would invest 

in mix of stocks and bonds. The investment of stocks carries higher risk, but this 

risk is necessary to provide the growth potential needed by someone who may live 

30 or more years after retirement. The fixed income securities provide stability to 

ensure that assets that will be needed for living expenses in the near term are not 

exposed to risk. There is no definitive asset allocation between stocks and fixed income securities in which a Target Date 2010 Fund should invest, and one could not 

argue that under no circumstances would it be appropriate for a 65-year-old retiree 

to have an 80 percent stock / 20 percent bond mix, but such a mix would fall well 

outside the generally expected asset allocation of a Target Date 2010 Fund. 

Mutual fund disclosure rules would allow a Target Date 2010 Fund to adopt such 

an 80 percent / 20 percent asset allocation. Notwithstanding that the Fund’s name 

suggests a substantially lower stock allocation, the description of the Fund’s investment objectives and style in its prospectus could correct this misimpression and investors would be expected to have read and understood such clarifying disclosure. 

Under current prospectus liability rules, the true nature of the Fund’s aggressive 

asset allocation strategy could even be omitted from the summary of its investment 

objectives and style in the summary prospectus as long as corrective disclosure appeared elsewhere in the full prospectus. (It is likely that some courts would find 

that even corrective disclosure buried in the Fund’s Statement of Additional Information, which is delivered to investors only upon request, would be a sufficient defense for prospectus liability purposes.) Thus, investors that expect the stock allocation suggested by the name of the Target Date 2010 Fund to be substantially lower 

than 80 percent and do not carefully scrutinize other fund disclosure documents will 

be subject to more risk than they expected. For example, a 45 percent decline in 

the stock market would result in a 36 percent decline in the value of their Fund 

shares, when they might have expected an 18 percent or 22.5 percent based on a 

40 percent or 50 percent stock allocation. 47

It is helpful to consider a recent example of this problem. A particular Target 

Date 2010 Fund has been criticized for declining 38 percent in value, but this decline is consistent with its aggressive asset allocation. The fourth page of the fund’s 

prospectus (for the relatively assiduous investor) states that each retirement fund: 

is managed to the specific year of planned retirement included in its name 

(the ‘retirement date’). The Strategies’ asset mixes will become more conservative each year until reaching the year approximately fifteen years 

after the retirement date (the ‘target year’) at which time the asset allocation mix will become static. 
120 

48Letter from Paul F. Roye, Director, SEC Division of Investment Management, to Craig Tyle, 

General Counsel, Investment Company Institute (Oct. 17, 2003). 

At this point, the prospectus has only reinforced the expectation that the 2010 

fund’s asset allocation strategy will reflect a stock allocation in the range of 40 percent to 50 percent. Under current law, this disclosure by no means created an expectation on which investors could actionably rely. Indeed the same paragraph includes 

a state that 15 years after retirement the static allocation would be: 27 percent 

short-term bonds, 37.5 percent other fixed-income securities, 25 percent equities and 

10 percent real estate investment trusts (‘‘REITs’’). From this, a very attentive investor could assume that the stock allocation at retirement would be fairly aggressive. The fifth page of the prospectus includes table that shows an expected allocation of approximately 77 percent 30 of the 2010 fund’s assets to equities, REITS and 

high-yield debt in the year before retirement. 

The problem is that this fund’s allocation is inconsistent with what many investors will expect from a Target Date 2010 Fund. There is no reason that this fund’s 

sponsor should not be allowed to offer a fund for retirees who wish to adopt an aggressive asset allocation. In combination with other investments the retiree might 

hold, the retiree’s overall asset allocation might fall within the more typical 40 percent to 50 percent range. But, in the words of a Fidelity executive, something called 

a ‘‘target-date’’ fund should follow a ‘‘one size fits most’’ strategy, and this fund fails 

that test. 

This problem is not limited to target-date funds. In some 529 plans, there are 

asset allocations designed for children expected to need the funds for college within 

one or two years that experienced substantial losses. These losses were inconsistent 

with the investment performance range one would expect from a conventionally constructed portfolio for such a short time horizon. Some of these 529 plans invested 

in bond funds that included ‘‘short-term’’ in the fund’s name, but their investment 

returns fall well outside of the variance one would associate with short-term bond 

funds. Many ‘‘short-term bond’’ funds held outside of 529 plans have produced abnormally high losses. 

To reiterate, the problem here is not that some funds have experienced substantial losses. To the extent that investors knowingly assumed the risk of large losses, 

criticizing these funds is somewhat unfair. For example, actively managed funds 

that lost 60 percent of their value while comparable markets lost only 40 percent 

provided their investors with returns that were within the range of variance from 

market returns that one assumes by accepting active management risk. One could 

criticize such funds for poor stock-picking, but it was the shareholder who chose to 

assume the active management risk that the fund would underperform the market. 

Similarly, the shareholder invested in a Target-Date 2050 Fund should expect to experience large losses when stock markets experience significant declines. In this 

case, it would be the Target-Date 2050 Fund that invested most of its assets in 

money market instruments that would be contradicting the asset allocation implied 

by its name. 

The SEC has had the opportunity to address the potential of fund names to mislead investors. Pursuant to a request from consumer advocates, the SEC adopted 

a misleading fund names rule in 2001. The rule fell far short of providing reasonable assurances that fund names that strongly implied a particular investment objective or style would stick to it. The rule allows ‘‘stock’’ funds to invest 100 percent 

of their assets in cash in emergency situations, ‘‘short-term bond’’ funds to risk substantial losses, ‘‘value’’ funds to invest primarily in growth stocks, and ‘‘target-date 

2010’’ funds to invest a more than 75 percent of their assets in equities. The SEC 

has taken the position that no matter how strongly a particular fund name implies 

a particular investment objective or style, the name’s potential to mislead investors 

can be entirely corrected through narrative disclosure that is often buried in fund 

documents. The SEC staff went out of its way to reassure fund managers that funds 

the included the term ‘‘U.S. Government’’ in its name could nonetheless invest 100 

percent of its assets in securities issued by Fannie Mae and Freddie Mac. 48 As I 

testified before this Committee in 2004, the term ‘‘U.S. Government’’ implies that 

the fund will invest in government-guaranteed securities, which Fannie Mae and 

Freddie Mac securities are not. 

Although investors should read prospectuses carefully before investing, I disagree 

that investors whose investments in a ‘‘target-date 2010’’ fund, a ‘‘shortterm bond’’ 

fund or 529 plan investment option for a 16-year-old that declined more than 40 

percent in one year are entirely to blame for their misfortune. Congress should 

enact legislation that meaningfully regulates fund names. It should require the SEC 

to prohibit the use of fund names that create a common expectation among investors 

regarding a fund’s investment objectives and style unless the fund invests consistent 
121 

49Many of these issues are discussed in greater detail at: Mercer Bullard, The Visible Hand 

in Government Sponsored Financial Services: Why States Should Not Sponsor 529 Plans, 74 U. 

Cin. L. Rev. 1265 (2006). 

with that style. The precise scope of the rule should be left to the SEC, but there 

should be no question that terms such as ‘‘target-date,’’ ‘‘short-term bond,’’ and 

‘‘value’’ would be covered. Fund sponsors use these terms in fund names precisely 

to communicate something about the fund to investors. They should not be permitted to contradict the fund name’s message with qualifying disclosure in fund documents. 

Some have criticized this position as requiring that the government dictate how 

funds invest. This argument is a red herring designed to divert attention from the 

real issue. The only restriction that would apply would be to the names that funds 

are permitted to use. The new rule would have no effect on any fund that chose 

a name that did not imply a particular investment objective or style. I strongly 

agree that free markets should determine what mutual funds invest in, not regulators. Requiring that all mutual funds invest only in a portfolio the returns of 

which will fall within a fairly predictable range would be inefficient, impracticable 

and inconsistent with basic principles of individual liberty. There are and should be 

mutual funds the variance of the investment returns of which essentially match the 

scope of the fund manager’s investment discretion. 

Requiring that a fund that uses a particular name produce predictably variable 

returns, however, does not implicate these concerns. When Magellan Fund manager 

Jeff Vinik invested a large amount of the Fund’s assets in fixed income securities 

prior to a run-up in the stock market in the late 1990s, the opportunity lost by its 

shareholders was a risk that they knowingly assumed. There is nothing about the 

name ‘‘Magellan Fund’’ that implies that its investment returns will reflect the variance that is characteristic of a particular market. Indeed, the name ‘‘Magellan’’ 

aptly suits a fund that may explore any and all investment opportunities around 

the globe. In contrast, it is misleading that a so-named ‘‘stock’’ fund can, consistent 

with its name, invest 100 percent of its assets in cash, or that something called a 

‘‘short-term bond’’ fund could lose 40 percent of its value in a single year. 

Fund Governance 

As indicated by this testimony, the breadth and depth of investor protection issues 

in the mutual fund industry that have been left unattended by regulators calls for 

new ideas on the most efficient structure for mutual fund regulation. The mutual 

fund scandal of 2003 also demonstrated the need for more independent boards. As 

described in greater detail in my March 23, 2004, testimony before this Committee, 

Congress should implement the following reforms to strengthen the oversight of mutual funds: 

• Create a Mutual Fund Oversight Board that would have examination and enforcement authority over funds and fund boards. 

• Require that a fund’s chairman be independent. 

• Require that a fund’s board be 75 percent independent. 

• Prohibit former directors, officers and employees of the fund manager from serving as independent directors. 

• Require that independent directors stand for election at least once every 5 

years. 

The Commission does not have the authority to impose any of these requirements 

on an unconditional basis. Each of these proposals requires Congressional action. 

529 PLANS 

As this Committee is aware, 529 plans have become an increasingly popular 

means for Americans to save for higher education. These plans have enjoyed enormous appeal in part because they offer a unique combination of federal and state 

tax benefits, high contribution limits, matching state contributions, donor control, 

automatic rebalancing and, in many cases, low costs. However, 529 plans also have 

been subject to criticism on the grounds of excessive and inadequately disclosed fees, 

inconsistent state tax treatment across different plans, and questionable sales practices. The following discussion briefly sets forth some of the issues relating to 529 

plans and proposes regulatory reforms. 49

Regulatory Oversight 

Permitting states to sell and regulate 529 plans has effectively added 50 new regulators for tax-deferred mutual fund wrappers (e.g., 401(k) plans, IRAs, Roth IRAs, 
122 

and 403(b) plans), which are subject to too many different regulators and sets of 

rules as it is. The Commission is responsible for fee disclosure for variable annuities, the Department of Labor is responsible for fee disclosure for employee benefit 

plans, and banking regulators and the Internal Revenue Service are responsible for 

fee disclosure for IRAs. Multiple disclosure regimes confuse investors and increase 

the costs of offering investment products, as each provider must tailor its program 

to the particular state’s requirements. The Committee should take this opportunity 

to explore ways of rationalizing fee disclosure and other regulatory aspects of various tax-deferred mutual fund wrappers. 

One option would be to assign exclusive oversight of 529 plans to the SEC. The 

SEC has greater experience and expertise in this area than any other government 

entity, and it would bring greater independence and objectivity to the creation and 

enforcement of 529 plan fee disclosure requirements. The states, as the issuers of 

interests in 529 plans, lack the independence and objectivity to regulate their own 

plans and to enforce any rules they might devise. Congress should consider specifically authorizing the Commission to establish comprehensive rules governing the 

529 plan fee disclosure, and consider expanding this responsibility to all aspects of 

529 plans operations. 

In addition, Congress should consider amending the municipal securities exemption to exclude 529 plans or permitting private firms to offer 529 plans outside of 

state sponsorship. The municipal exemption under which 529 plans operate was not 

intended for the offering of retail financial services, but for the conduct of bona fide 

government activities. There is nothing state-specific about 529 plans that could not 

be accomplished outside of the framework of a money management structure. 

Fee Disclosure 

Some commentators have criticized 529 plans on the ground that the high fees 

charged by many plans have reduced the potential tax benefits of the plans. Indeed, 

one commentator decried a plan that consumed more than 10 percent of participants’ balances each year for two years. Determining whether a particular fee is too 

high or too low, based solely on the amount of the fee, is a difficult and uncertain 

exercise. In my view, the best way to promote efficient pricing is through standardized, transparent disclosure of fees. It is generally accepted that standardized, 

transparent fee disclosure promotes competition and reduces prices. The disclosure 

of 529 plan fees, however, is generally incoherent and obscure, and 529 plans would 

likely be forced to reduce their fees if adequate fee disclosure were provided. 

The lack of transparent, prominent, standardized disclosure of 529 plan fees is exacerbated by factors in the 529 plan context that make fee disclosure even more important than in other contexts. In effect, certain governmental entities have been 

granted an exclusive monopoly to sell a particular tax-deferred investment product 

in competition with private providers of other tax-deferred investment products. 

This intrusion of the government into the private sector may distort many functions 

of the financial services markets, including the setting of fees. 

For example, investors may lower their guard when evaluating 529 plans on the 

assumption that a public-minded governmental entity would sell only a high quality, low-cost investment product. In fact, states’ interests may not be aligned with 

plan participants’ interests with respect to negotiating fees and choosing investment 

options, and investors’ trust in states’ motivations and interests may be misplaced. 

States may have incentives to offer plans that charge high fees. States may charge 

high fees as a means of increasing their general revenues, or charge higher fees to 

out-of-state residents as a way to subsidize services provided to instate participants. 

Political considerations also may influence the selection of money managers and 

cause states to be less diligent when negotiating fees. For example, states may favor 

in-state money managers or managers that have contributed to the election campaigns of state officials. State officials may even use 529 plan assets for self-promotion. 

Further, participants in 529 plans have limited control over fees. Mutual funds 

can raise advisory and 12b-1 fees only with shareholder approval, whereas states 

generally can raise fees at will without notice to participants, thereby making it 

more important that investors understand the fees charged before making an investment decision. When a mutual fund that is a 529 plan investment option seeks to 

raise its fees, the state has the right to vote on the fee increase, but, as noted above, 

it may not have the same interests to negotiate low fees as plan participants have. 

Finally, federal law gives mutual fund shareholders legal recourse against a fund’s 

directors and manager with respect to excessive fees charged by the manager, which 

may provide some restraint on fees. Participants in 529 plans, however, have no 

such rights absent a violation of the antifraud rules under the federal securities 

laws. 
123 

Restrictions on 529 plan investment options, participants’ limited control over fees 

and fee increases, the costs and burdens of transferring from one plan to another, 

states’ monopoly on state tax benefits, limited legal recourse against plan sponsors, 

and the divergence of state and participant interests are some of the special factors 

that make it especially critical that 529 plan fees be fully disclosed in an understandable, standardized, accessible format. 

These special factors militate for prompt Congressional action to ensure that 529 

plans are required to provide standardized, transparent, prominent fee disclosure. 

In short, fee disclosure for 529 plans, at a minimum, should be: 

• Standardized, both in the way in which the fees are calculated and the terms 

used to describe the fees; 

• Prominently disclosed relative to other information about the plan; 

• Presented both as a percentage of assets and a dollar amount, and on an illustrative and individualized basis; 

• Inclusive of a total expense ratio for each investment option that includes all 

fees incurred in connection with an investment in the plan, to include, among 

other things, portfolio transaction costs, distribution costs, operating costs and 

administrative fees, whether charged by the state, plan manager, investment 

manager, or other person; 

• Inclusive of a pie chart that illustrates the components of the total expense 

ratio according to standardized categories of fees, such as investment management, administrative services, and marketing and distribution; 

• Inclusive of information on fees charged by other 529 plans both in a disclosure 

document and in an easily accessible format on the Internet; and 

• Inclusive of separate disclosure of all payments received by intermediaries for 

executing the transactions in plan interests, both as a dollar amount and percentage of assets, whether or not the payment is made directly by the participant. 

As discussed above, Congress should ensure that fee disclosure requirements for 

529 plans are promulgated and enforced by an independent, objective government 

entity. 

Disparate State Tax Treatment 

Most states that permit state deductions for 529 plans limit the deductions to the 

in-state plan. This disparate state tax treatment of 529 plans distorts the marketplace for investment products. Investors may opt for a higher-cost, in-state plan specifically in order to receive the tax benefits of the in-state plan, or may miss out 

on the in-state tax benefit offered by a low-cost in-state plan because brokers recommend out-of-state plans that pay higher compensation to the broker. 

The disparate state tax treatment of 529 plans has the effect of reducing price 

competition among 529 plans because in-state plans can exploit their monopoly on 

in-state tax benefits to offset their higher fees. This is essentially a kind of bundling, not dissimilar to a private company that has a government-granted monopoly 

over one product (state tax deductions) to help it sell another, possibly inferior product (the 529 plan). States will inevitably exploit this monopoly to the detriment of 

investors in 529 plans. The unavailability of state tax deductions for out-of-state 

plans may further undermine market efficiency and create incentives to charge 

higher fees, as discussed in the next section. A small minority of states have extended their state tax deduction to out-of-state 529 plans, but most continue to frustrate Congress’s intent in creating the plans. Congress should consider mandating 

that any state tax deductions for 529 plan contributions or distributions be reciprocal across all qualified 529 plans. 

HEDGE FUNDS 

Systemic Risk 

There is no question that hedge funds are a potential source of systemic risk, that 

is, the kind and scope of financial risk that is systemic in the sense of posing a 

threat to our political, social and economic systems. Systemic risk warrants government oversight because our society might not be able to absorb an extreme contraction of free financial markets without long-term damage to political, economic and 

social institutions. This concern militates for appropriate prudential oversight of 

hedge funds, such as requirements that they report net positions and leverage ratios. 

This does not mean that hedge funds or their advisers should be subject to substantive regulation, however. It is important that capital be allowed to flow to un-
124 

50See After Blackstone: Should Small Investors Be Exposed to Risks of Hedge Funds? Hearing before the Subcommitee on Domestic Policy, Committee on Oversight and Government Reform (July 11, 2007) (testimony of Mercer Bullard); Mercer Bullard, Regulating Hedge Fund 

Managers: The Investment Company Act as a Regulatory Screen, 13 Stanford J. Law, Bus. & 

Fin. 286 (2008). 

regulated intermediaries such as hedge funds. Investment in hedge funds is limited 

to sophisticated investors, and these investors are presumed to be in the best position to protect their interests without costly governmental oversight. Substantive 

regulation of hedge funds will simply drive sophisticated capital offshore and provide little benefit to the financial markets. As discussed below, however, the SEC 

has permitted hedge funds to be sold to unsophisticated investors in certain circumstances. 

Public Offering of Hedge Funds 

In 2007, the SEC effectively decided to permit hedge funds to publicly offer their 

shares. These hedge funds argued that they reflected investments in hedge fund 

managers, not in the funds, yet the value of interests that they sold were predominantly depended on the success of their funds. The financial structure of these public companies is closer to a hedge fund than to a conventional money manager, 50

and the behavior of the stock prices of public hedge funds and conventional money 

managers over the last two years has reflected the significantly greater risks posed 

by the former. As predicted, these publicly held hedge funds are acting like hedge 

funds, not money managers. Much attention is being—and should be—paid to the 

systemic risk posed by hedge funds, but too little has been paid to the sale of hedge 

fund interests to unsophisticated investors. If the SEC continues to be unwilling to 

ensure that hedge funds are sold only to sophisticated investors, Congress should 

prohibit the public offering of shares of these entities. 

Accredited but Unsophisticated Investors 

Under current law, persons with net worth of $1 million either alone or with their 

spouse qualify to invest in hedge funds. The SEC has conceded that this test, which 

has not been adjusted since 1982, has made millions of new investors eligible to invest in hedge funds at the same time that ‘‘private pools have become increasingly 

complex and involve risks not generally associated with many other issuers of securities.’’ The Commission estimated that the minimum net worth requirement, if adjusted only for inflation and disregarding the issue of increased complexity, would 

have been $1.9 million as of July 1, 2006. That year, the Commission issued a modest proposal to increase the $1 million minimum to $2.5 million. That minimum 

would be inflation-adjusted again on July 12, 2012, and every 5 years thereafter. 

In 2007, the Commission requested additional comments on the proposal, but almost 

three years after the initial proposal, the Commission has yet to take final action. 

The effect of the SEC’s position is that a newly retired couple with $700,000 investments and a $300,000 home—the SEC continues to count a person’s personal 

residence counts toward the $1 million net worth minimum while conceding that the 

‘‘value of an individual’s primary residence may have little relevance with regard 

to the individual’s need for the protections of Securities Act registration’’—is sophisticated enough to invest in a hedge fund. With $700,000 in investments, a retired 

couple’s typical withdrawal rate would be 4 or 5 percent annually, or about $31,000 

per year, plus Social Security income and, in some cases, a company pension. Even 

assuming additional income of $20,000 per year (which would not be needed for the 

couple to meet the SEC standard), it is self-evident that this couple’s net worth in 

no way qualifies them to risk their retirement security in a hedge fund. Nearly 

three years after its initial proposal (and 27 years after the $1 million minimum 

was first established), the SEC continues to permit hedge funds to prey on unsophisticated investors. Congress should take steps to ensure that any individual net 

worth standard for private offerings bears a reasonable relationship to the likely financial sophistication of the purchaser. 

INVESTMENT ADVISERS 

Fiduciary Standard 

It is hard to understand how, after years of regulatory review, the simple question 

of whether those who provide individualized investment advice should be subject to 

a fiduciary standard has not been answered. It is accepted that professionals who 

provide individualized, technical advice similar to investment advice—e.g., lawyers 

and doctors—are fiduciaries. They are required to act solely in their clients’ best interests. They may charge higher fees than other advisers, but their fees must be 

fair. The must disclose all potential conflicts of interest to their clients. In many 
125 

51See, e.g., Letter from Mary Schapiro, Vice Chairman and President, NASD, and Elisse Walter, Executive Vice President, NASD to Annette Nazareth, Director, Division of Market Regulation, and Meyer Eisenberg, Acting Director, Division of Investment Management, U.S. Securities 

and Exchange Commission (Apr. 4, 2005) available at http://www.sec.gov/rules/proposed/ 

s72599/nasd040405.pdf 

cases, doctors and lawyers are prohibited from assuming a conflicted role no matter 

what amount of disclosure they provide. 

The Supreme Court agrees. In the Capital Gains decision, it held that investment 

advisers are subject to a fiduciary duty to their clients. Yet the SEC and FINRA 

have taken the position that when brokers provide individualized advisory services 

to their clients, they should not necessarily be subject to a fiduciary duty, even 

when they charge a separate, asset-based fee and advertise themselves as ‘‘financial 

consultants,’’ ‘‘financial planners,’’ and ‘‘wealth managers.’’ In the narrow circumstances in which the SEC would consider a broker to be an adviser, such as 

when it had provided a variety of financial planning services to a client, the SEC 

still would allow the broker to revert to a non-fiduciary role in executing the financial plan. As a practical matter, the ‘‘financial consultant’’ can provide a generic financial plan subject to a fiduciary duty, and then take off its fiduciary hat when 

selling the client mutual funds that pay the broker higher distribution fees than 

other funds without disclosing the fees. As long as the funds are suitable, which 

they generally will be, the broker has acted consistent with FINRA’s standards of 

conduct. 

The SEC’s approach to this issue has been consistently anti-investor. Ten years 

ago, it adopted a rule that expressly eliminated Congress’s requirement that the 

broker exclusion apply only if the broker receives no special compensation for investment advisory services. The rule also read Congress’s requirement that the advisory 

services also be ‘‘solely incidental’’ so broadly so as to be meaningless. The SEC took 

the position that advice was solely incidental if the advisory services were provided 

‘‘in connection with and reasonably related to’’ brokerage services. As stated in an 

amicus brief filed by Fund Democracy and the Consumer Federation, ‘‘[t]he Commission’s ‘in connection with and reasonably related to’ standard sets no limits on the 

degree of advisory services provided in relation to the brokerage services, much less 

in any way limit the advisory services to those that are ‘minor’ or otherwise ‘incidental.’’ ’’ 

Congress needs to take action to end this debate. For over a decade, the SEC has 

been unable to muster the backbone to defend fiduciary standards for investment 

advisers, and the current SEC Chairman and one Commissioner spent years defending FINRA’s self-interested position that a suitability standard is adequate, 51 notwithstanding that, for example, it does not require the disclosure of conflicts of interest. Congress should enact legislation that imposes a fiduciary duty on any persons who provide individualized investment advice or sell products pursuant to their 

providing of such individualized investment advice. Americans who naturally expect 

those providing fiduciary services to act solely in their clients’ best interests are entitled to nothing less. 

Madoff Scandal 

It should not be necessary to include the Madoff scandal as a separate category 

in this testimony, but the import of the scandal for investment adviser regulation 

has been so distorted that some clarification is necessary. We still don’t know exactly how Madoff perpetrated his fraud, except that he did so without detection for 

many years. Some have argued that this reflects a failure of investment adviser regulation despite the fact that he was exclusively regulated as a broker-dealer during 

most of the period of the fraud. These arguments may simply reflect nothing more 

than a short-sighted political strategy to curry favor as the preferred choice as the 

SRO for the adviser industry, but they nonetheless need to be addressed. I agree 

that an SRO for advisers would be appropriate, but if the Madoff scandal has revealed anything with respect to this issue, it is that some regulators lack a full understanding of the nature of investment adviser services and regulation and could 

not adequately protect investors’ interests in overseeing the investment adviser industry. 

During most of the period during which Madoff defrauded his clients, he was not 

registered as an investment adviser—he was registered as a broker. It appears that 

he was not registered as an investment adviser because the SEC had interpreted 

the broker exclusion from the definition of investment adviser for ‘‘solely incidental’’ 

investment advice to be available for discretionary accounts. The SEC has since 

abandoned this ill-advised position, but during most of Madoff’s illegal activities he 

was able to rely on the exclusion and was regulated solely as a broker. Thus, while 
126 

52See Susan Antilla, Investors happily handed Madoff Billions, Business Times (Dec. 17, 

2008) (Madoff’s ‘‘company Web site describes him as ’a major figure in the National Association 

of Securities Dealers’, the regulatory agency now known as Finra. He was board chairman of 

the Nasdaq Stock Market; was on the board of governors of the NASD; sat on an advisory committee for the Securities and Exchange Commission (SEC); and was chairman of the trading 

committee of Sifma, formerly the Securities Industry Association.’’). 

FINRA, the SRO responsible for broker oversight, has suggested that the Madoff 

scandal illustrates the risk of ‘‘the absence of FINRA-type oversight of the investment adviser industry,’’ this position is belied by the undisputed fact that Madoff 

was subject only to broker regulation during most of the relevant period. 

FINRA’s position is understandable and not necessarily a negative reflection on 

its capacity as the broker SRO. Its leadership lacks a deep understanding of and 

experience with investment adviser regulation, and it has a close relationship with 

and is naturally protective of the brokerage industry. Its sometimes excessive exuberance for extending its jurisdiction over functionally dissimilar services is a common, unavoidable symptom of agency politics, especially in the inexperienced hands 

of new leadership. And one would expect that a fraud perpetrated by a man who 

for years served in a variety of leadership roles with FINRA’s predecessor (the 

NASD), and who used the luster that the NASD gave his reputation to help entice 

unknowing victims, would put FINRA on the defensive and make its objective evaluation of the situation difficult. 52 Indeed, FINRA’s precipitate response to the 

Madoff scandal is quite understandable, but it is also, unfortunately, evidence that 

it is not capable of providing effective self-regulation of the investment adviser industry. 

This is not to say that the Madoff scandal tells us nothing about investment adviser regulation. As noted, it 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. 

In addition, during the last stages of the scandal Madoff was registered as an investment adviser. His registration statement indicated that he had custody of $17 

billion in assets under management. The Investment Advisers Act generally requires that an investment adviser maintain custody of client assets with a broker 

dealer or a bank, and in doing so relies on FINRA and banking regulators to ensure 

that the custodied assets actually exist. In view of reports that much of the Madoff 

related losses will be covered by SIPC, it appears that the failed custody arrangement was with a broker. It is unclear why, if the stolen assets were custodied by 

a broker, regular broker examinations by Madoff’s SRO did not uncover the fraud. 

As discussed below, such prudential oversight should be assigned to a prudential 

regulator, not to a regulator such as FINRA with concurrent investor protection jurisdiction. A regulator such as FINRA should focus solely on what it knows and does 

best: regulating the sales activities of brokers. 

A final word is necessary regarding the argument made by some that the Madoff 

scandal demonstrates the weakness of a fiduciary standard. A fiduciary duty is not 

designed to nor could it protect investors from those who are willing to steal their 

money outright. The Madoff scandal is no more a reflection on the fiduciary standard (or FINRA’s lower suitability standard) than would be a bank robbery. What 

would have detected Madoff’s fraud is adviser registration triggered by the providing of individualized investment advice and competent examinations of his custody arrangements. 

Principal Trading Exemption 

One of the primary reasons that brokers seek to avoid triggering investment adviser regulation is the principal trading prohibition. Section 206(3) of the Investment Advisers Act requires that investment advisers obtain written notice and consent from their clients prior to completion of the transaction in which the adviser 

acts in a principal capacity. Brokers chafe under the requirement to obtain client 

consent prior to every principal trade, and they hoped to be relieved of this restriction by the SEC’s proposed rule excluding virtually all brokers managing nondiscretionary accounts from the definition of investment adviser (known as the ‘‘Merrill 

Rule’’). When the Merrill Rule was vacated by the Court of Appeals, the SEC quickly sought to accommodate brokers’ concerns by adopting an interim rule that exempted virtually all trades not conducted in a discretionary account from section 

206(3). 
127 

53See Letter from Mercer Bullard, President and Founder, Fund Democracy and Barbara 

Roper,Director of Investor Protection, Consumer Federation of America to Nancy Morris, Secretary, U.S. Securities and Exchange Commission (Nov. 30, 2007) available at http:// 

www.funddemocracy.com/principal%20trading%20ltr%2011.30.07.pdf 54These findings in a series of articles published in 2001, see Mercer Bullard, PaytoPlay in 

America, TheStreet.com (Apr. 26–30, 2001), available at http://www.thestreet.com/funds/ 

mercerbullard/1406251.html, and a state-by-state guide to pay-to-play practices uncovered by 

the SEC is posted on Fund Democracy’s Web site. See http://www.funddemocracy.com/Pay-toPlay%20Page.htm 

Before considering this interim rule, some history on the SEC’s ill-advised Merrill 

Rule is in order. As with the principal trading exemption, the SEC effectively adopted the Merrill Rule without prior notice and consent. The SEC took a no-action position with respect to activity conducted within the proposal’s purview, thereby circumventing Administrative Procedures Act requirements. Those who opposed the 

rule were left in limbo waiting for the Commission to adopt a final rule so that it 

could be challenged in court. Almost five years later, the Commission had yet take 

final action on the rule and the Financial Planning Association sued to force a final 

resolution of the issue. The SEC reproposed the rule in 2004, and then again in 

2005. It finally adopted the rule in 2005, after it had been in operation for almost 

six years, and the Court of Appeals vacated the rule in its entirety in 2007. 

Even before the Court’s order went into effect, the SEC embarked on the same 

path of adopting effectively final rules without prior notice and comment. It scheduled its ‘‘interim’’ exemption from section 206(3) to expire more than two years after 

its adoption. The SEC’s repeated abuse of notice and comment procedures undermines faith in the rule of law and the administrative process, especially when it 

abuses its authority by enacting broad exemptions from carefully crafted laws enacted by Congress specifically to protect investors against abusive transactions. 

In this instance, the interim rule has created significant investor protection gaps 

that continue to remain unaddressed. For example, the rule does not expressly require firms to develop policies and procedures that are specifically designed to detect, deter and prevent disadvantageous principal transactions. Such procedures are 

necessary to ensure that the fairness of the price at which the principal trade is 

effected can be objectively verified. The market’s current difficulty in valuing certain 

fixed income securities that previously were considered relatively liquid and easily 

valued illustrates the potential risk. Securities that are difficult to value often are 

more likely to be securities that an adviser may be attempting to dump on its clients. The incentive to engage in the abuses that section 206(3) is designed to prevent rises with the difficulty of determining whether the transaction was fair. Congress should insist that the SEC take prompt action to address this and other concerns relating to the principal trading exemption. 53

Pay-To-Play Ban 

In August 1999, the SEC proposed to prohibit money managers from engaging in 

pay-to-play. The Commission had thoroughly documented the practice among public 

pension officials of awarding investment management business to large political donors. 54 The retirement accounts of millions of our nation’s schoolteachers, fire fighters, police officers and other public servants were being invested by money managers who qualify for the job not by earning it, but by financing the political campaigns of public pension fund officials. The SEC’s proposal was elegantly simple. It 

would have required that money managers give up any compensation they received 

for managing public money for two years after the firm, its executives or agents 

made a campaign contribution to an elected official or candidate who could have influenced the selection of the money manager. 

The pay-to-play proposal was modeled on Rule G-37, which prohibits municipal 

bond underwriters from contributing to the campaigns of elected officials who may 

influence the award of bond underwriting contracts. The rule is widely credited with 

cleaning up the municipal bond industry. An unfortunate byproduct of Rule G-37 

has been its incidental effect on pay-to-play in the money manager arena. State 

treasurers and other elected fiduciaries of municipal pension funds saw campaign 

contributions from municipal underwriters dry up, so they turned to money managers and lawyers doing business for the pension funds to make up the difference. 

Pay-to-play practices continue to plague the awarding of money management business by public pension funds at the same time that public pension underfunding has 

reached crisis proportions. It is imperative that managers tasked with restoring financial stability to public pension plans are not selected on the basis of political 

favor, but on the basis of their expertise and experience. This will not happen as 

long as the SEC allows investment advisers to pay-to-play in the public money man-
128 

agement arena. Congress should strongly encourage the SEC to repropose the payto-play rule and see it through to final adoption. 
129 

PREPARED STATEMENT OF ROBERT PICKEL 

EXECUTIVE DIRECTOR AND CHIEF EXECUTIVE OFFICER, 

INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION

MARCH 10, 2009 

Mr. Chairman and Members of the Committee, thank you very much for allowing 

ISDA to testify at this hearing. We are grateful to the Committee for the opportunity to discuss the privately negotiated derivatives business and more specifically, 

the credit default swaps market. This business is an important source of innovation 

for our financial system—it is one that employs tens of thousands of individuals in 

the United States and benefits thousands of American companies across a broad 

range of industries. 

About ISDA 

ISDA, which represents participants in the privately negotiated derivatives industry, is the largest global financial trade association, by number of member firms. 

ISDA was chartered in 1985, and today has over 850 member institutions from 56 

countries on six continents. These members include most of the world’s major institutions that deal in privately negotiated derivatives, as well as many of the businesses, governmental entities and other end users that rely on over-the-counter derivatives to manage efficiently the financial market risks inherent in their core economic activities. 

Since its inception, ISDA has pioneered efforts to identify and reduce the sources 

of risk in the derivatives and risk management business. Among its most notable 

accomplishments are: developing the ISDA Master Agreement; publishing a wide 

range of related documentation materials and instruments covering a variety of 

transaction types; producing legal opinions on the enforceability of netting and collateral arrangements; securing recognition of the risk-reducing effects of netting in 

determining capital requirements; promoting sound risk management practices; and 

advancing the understanding and treatment of derivatives and risk management 

from public policy and regulatory capital perspectives. 

In my remarks today, I would briefly like to: 

• Describe how CDS contracts works and the benefits they provide; 

• Clarify the level of exposure in the CDS business; 

• Discuss the robust infrastructure that industry participants have developed to 

support the CDS business; 

• Review the role of CDS in today’s financial crisis; and 

• Outline my views on the evolution of the regulatory framework for privately negotiated derivatives. 

As I cover these topics, I hope to clarify some key misperceptions regarding the 

CDS business: 

• The first is that, even in the face of a significant increase in defaults and the 

collapse of major financial institutions, the CDS business has continued to function. Credit derivatives have remained available as a means to manage risk in 

today’s financial markets; 

• Second, as recent events have proven out, the risks related to the CDS business 

have been widely misunderstood; 

• Third, the CDS business operates within a robust infrastructure that incorporates time-tested standards, practices and principles; 

• Fourth, CDS are not responsible for today’s financial crisis; and 

• Finally, the CDS industry continues to work with policymakers to improve and 

evolve how we do business. 

How Credit Default Swaps Work 

Credit default swaps are simple financial transactions negotiated between two 

counterparties. They enable firms to transfer and more effectively manage risk. 

In the real world, CDS play an important role in the growth and functioning of 

our nation’s economy: 

• CDS facilitate the flow of credit to American businesses; 

• CDS lower borrowing costs for American companies; and 

• CDS provide vital information to the market about the creditworthiness of borrowers. 
130 

OTC derivatives exist to serve the risk management and investment needs of endusers such as the businesses that are the backbone of our economy and the investors that provide funds to those businesses. The development of OTC derivatives has 

followed the development of the American economy. For centuries, foreign exchange 

transaction have facilitated trade and helped American businesses expand; they 

were one of the original banking powers recognized in the National Bank Act of 

1863. The first OTC derivative linked to interest rates was transacted in the early 

1980s between IBM and the World Bank, helping IBM raise funds on more favorable terms. Today, over 90 percent of the Fortune 500, 50 percent of mid-sized companies and thousands of other smaller American companies, use OTC currency and 

interest rate derivatives. Credit derivatives first appeared in the mid-1990s as a tool 

to help banks diversify the credit risk in their loan portfolio, and they have grown 

into a vital risk management and diversification tool. In each case the need for 

these products was driven by the needs of end-users, and their growth was a direct 

function of their utility to end-users. If end-users did not want these products, they 

would not exist. 

It might be helpful to provide an example of the needs that credit derivatives address. Imagine a bank that wants to lend more to American companies in a particular sector of the economy, or a particular geographic region, but that does not 

have relationships with those companies. That bank could enter into a credit derivative transaction with a bank that does have loans to those companies, whereby the 

first bank would sell protection to the second bank on those companies, taking on 

some of the second bank’s credit exposure to those companies in exchange for periodic payments. This transaction benefits both banks: the first bank diversifies its 

loan portfolio and earns income and the second bank is able to lend more money 

to those companies and deepen its relationship with them. Equally importantly, this 

transaction also benefits the companies themselves. It expands their funding 

sources and thus allows them to get better rates on their borrowings. 

CDS can also be used to hedge against other risks related to the potential default 

of a borrower. For instance, an auto parts company that is heavily reliant on one 

auto manufacturer as its primary customer might seek to protect itself against the 

risk that manufacturer will go out of business by purchasing protection in the form 

of a CDS on that company. 

These credit derivatives, so-called single-name credit default swaps because they 

provide default protection on a single entity, were the foundation of the credit derivatives market and still constitute the vast majority of the market. These trades 

help American companies raise money more cheaply, and they help American investors diversify risk and seek out attractive investment opportunities. To that end, 

Warren Buffett wrote this year in his letter to Berkshire Hathaway shareholders 

that he has started to use single name CDS to sell protection and that he would 

like to enter into more such transactions. The utility of such credit derivatives to 

investors and to companies is what makes them so valuable to the American economy. 

Growth and Size of the CDS Business 

Because of the important role they play in enabling firms to more precisely manage risk, the CDS business has grown significantly in a relatively short period of 

time. The most common measurement of the size of the CDS business is notional 

amount. For CDS, this represents the face value of the bonds and loans on which 

participants have written protection. 

While using notional amount as a measurement tool for the size of the privately 

negotiated derivatives business has its benefits, it also has a major drawback. Notional amount greatly overstates the actual exposure represented by the CDS business. One reason for this is because a seller of protection often seeks to hedge its 

risk by entering into offsetting transactions. Using the example above, if the 

counterparty that sold $10 million of protection wished to hedge its risk and buy 

protection, it too would enter into a $10 million CDS contract. Thus, there are now 

two CDS contracts outstanding with a total notional amount of $20 million. The reality is, however, that only $10 million is at risk. 

The Depository Trust and Clearing Corporation recently began publishing market 

data based on information compiled for their Trade Information Warehouse. According to DTCC, the net notional amount outstanding—which represents the maximum 

possible net funds transfer between net sellers and net buyers of protection that 

could be required upon the occurrence of a credit event—is $2.6 trillion. 

This may seem like a large number, and it is. But consider what it represents: 

the sum total of payouts if all reference entities were to default. This is, to say the 

least, unlikely. What’s more, the average of the net notional amount across the reference entities in the DTCC warehouse is $2.6 billion. And this actually overstates 
131 

the potential losses, because it excludes any recovery value that sellers of protection 

might receive. The point here is that the net payout on an individual reference entity basis is manageable. This was aptly demonstrated by the Lehman default, where 

the amounts paid on settlement were handled with no disruption to the system. 

One additional point regarding the size and risks of the CDS business bears mentioning. CDS do not create new risks. They enable firms to transfer risk that already exists. This risk-shifting process is a zero-sum arrangement; what the buyer 

potentially gains by buying protection, the seller potentially loses by selling protection. The amount that the seller of protection loses is identical to the risk that the 

buyer originally held. 

CDS Infrastructure 

Privately negotiated derivatives are often referred to as ‘‘OTC derivatives,’’ with 

the implication being that this is an unregulated business with no structure, standards or principles governing it. As someone who has been involved in building a robust infrastructure for privately negotiated derivatives for virtually my entire professional career, this misperception is perhaps the most frustrating among those 

that characterize the CDS business. 

The truth is, there is a robust infrastructure for CDS and other swaps that has 

been developed over the past 25 years by ISDA, industry participants and policymakers around the world. The growth, strength, and success of the business could 

not have been achieved without it. 

A case in point: some believe that, in the OTC derivatives business, all kinds of 

firms can enter into all types of CDS contracts with each other. This is simply not 

the case. The fact is, banks are the primary market makers in the CDS business, 

and firms wishing to trade CDS need to have credit lines with them. Of the trades 

in the DTCC warehouse, virtually all involve at least one dealer and 86 percent are 

between two dealers. These dealer banks, in turn, impose a variety of requirements 

on their counterparties (and vice versa) in terms of the maximum exposure they will 

take, the imposition of collateral requirements, and so on. Virtually all of the exposure in the CDS business originates within the heavily regulated banking system. 

Another example of the industry’s infrastructure at work: at the core of every 

CDS transaction is a contract negotiated and entered into between two firms. The 

specific terms of the contract—its amount, the premium payment, its duration, 

etc.—are determined by the counterparties and are codified in a confirmation agreement between them. 

Underlying the confirmation is the widely used ISDA Master Agreement, which 

includes standardized language on definitions and other contract terms. The ISDA 

Master is widely recognized as a groundbreaking document that has enabled the 

growth of the risk management industry by enhancing legal certainty and reducing 

credit risk. It establishes key international contractual standards, and its importance to the global financial community has been described as ‘‘no less than the creation of global law by contractual consensus.’’ Reflecting its wide acceptance, the 

vast majority of derivatives transactions executed annually are documented under 

the ISDA Master. 

In addition to the standardized legal architecture governing privately negotiated 

derivatives, the industry has also worked to develop sound practices in other areas. 

These include risk management, the use and management of collateral, and the incorporation of technology into the derivatives business. 

The industry’s work to further strengthen and improve the infrastructure and 

platform upon which it operates is never-ending. The industry has, for example, 

greatly improved transparency through the publication of information in DTCC’s 

trade information warehouse, and significant progress has been made to reduce 

operational risk in the confirming, settling, and clearing of CDS. 

The Role of CDS in Today’s Financial Crisis: Bear, Lehman, AIG 

Over the past year, CDS have received a significant amount of attention because 

of concerns about their role in the current financial crisis. More specifically, issues 

have been raised regarding whether CDS created the financial crisis and/or played 

a significant part in the Bear Stearns, Lehman Brothers, and AIG situations. 

It is by now clear that the roots of the current financial crisis lie in imprudent 

lending decisions, particularly with respect to residential housing, but also extending to other areas including consumer receivables, auto finance and commercial development. These imprudent decisions were in part the result of an ‘‘easy money’’ 

environment and a mispricing of risk. They were in turn exacerbated by distortions 

in ratings models that underestimated both the risk of individual securities as well 

as how closely correlated the risks of those securities were within portfolios. 
132 

If CDS did not cause the crisis, did they make it worse? Some industry observers 

cite the Bear Stearns situation in answering this question. While it may seem far 

longer, it was only a year ago that Bear Stearns suffered a liquidity crisis that led 

to its eventual purchase by JPMorgan Chase. As this drama unfolded, there were 

widespread concerns that Bear’s failure as a derivatives counterparty would have 

systemic implications. The theory was the CDS and other privately negotiated derivatives supposedly created an interlinking web in which a shock from one participant could capsize others. 

The fact is, Bear’s problems were primarily related to a lack of confidence from 

its lenders and its resulting inability to secure institutional funding to run its business. It was a classic liquidity squeeze for an institution that apparently relied too 

much on short-term funding. The role of swaps in this situation was at best cursory. 

As for the systemic risk fears related to Bear’s role as a swaps counterparty, subsequent events have proven this supposition to be groundless. Lehman was larger 

than Bear Stearns—a bigger institution with a bigger derivatives portfolio—and its 

bankruptcy created no system fissures. 

In fact, by the time of the Lehman default in September, the focus had shifted. 

No longer were market observers especially worried about the failure of a large derivatives counterparty. Concerns centered on the implications of a failure of a reference entity upon which a significant level of credit protection had been sold. 

Here, too, however, the fears were overblown. Contrary to rumors, the actual pay- out on CDS contracts in which Lehman was a reference entity was about $5 billion—far less than some industry critics initially thought. By all accounts, the Lehman bankruptcy and default was processed well by the industry, testifying to its 

strength and resilience. 

Moving now to AIG: Last week, this Committee heard testimony on the regulatory 

failures that contributed to the terrible situation at AIG. We also heard Chairman 

Bernanke express his frustration with AIG, stating that it acted like an unregulated 

hedge fund. 

The truth, however, is far worse. First, it’s clear that AIG was in fact regulated. 

Its supervisors apparently knew how much mortgage risk it was taking on in its 

credit protection and securities lending business. They also knew that AIG included 

ratings triggers and collateral requirements in its contracts in order to gain additional counterparty capacity. 

In addition, a hedge fund would not have been allowed to build up such a large, 

uncollateralized positions with so many counterparties. In fact AIG Financial Products operated far more recklessly than most hedge funds or, for that matter, other 

businesses engaged in similar activities. It is worth noting these practices were contrary to the generally accepted practices advanced by ISDA for the last 20 years. 

In short, the causes of the AIG situation are clear. First, AIG’s Financial Products 

subsidiary took on too much exposure to subprime mortgage debt. As the ratings 

on that debt were downgraded, the company’s own ratings came under pressure. 

Under agreements with its counterparties and customers, AIG was then forced to 

post ever increasing amounts of collateral with them. In short, AIG took on too 

much exposure to subprime debt, and failed to appropriately manage its collateral 

and liquidity. It was a collective risk, liquidity, and collateral management failure, 

facilitated by poor supervision and an overreliance on rating agency models. 

The Continued Evolution of the CDS Business 

As noted previously, the CDS industry is committed to further strengthening and 

improving how we do business. This includes working with policymakers to address 

areas of mutual concern. 

On November 14 the PWG announced a series of policy objectives for the privately 

negotiated derivatives industry. The PWG broke their recommendations into four 

broad categories: (1) improve the transparency and integrity of the credit default 

swaps market; (2) enhance risk management of OTC derivatives; (3) further 

strengthen the OTC derivatives market infrastructure; and (4) strengthen cooperation among regulatory authorities. 

ISDA agrees with these four objectives, and believes that continuing to pursue the 

improvements industry and regulators have worked on over the last several years 

is key to ensuring the OTC derivatives industry in the United States remains 

healthy and competitive. 

Within those four broader objectives the PWG lists a number of specific recommendations. These can be separated into: 

• Recommendations for policymakers (e.g., ‘‘Regulators should establish consistent 

policy standards and risk management expectations for CCPs or other systemically important derivatives market infrastructures and apply those standards 

consistently’’); 
133 

• Recommendations for industry (e.g., ‘‘Market participants should adopt best 

practices with respect to risk management for OTC derivatives activities, including public reporting, liquidity management, senior management oversight 

and counterparty credit risk management’’); 

• Recommendations of an operational nature (e.g., ‘‘Details of all credit default 

swaps that are not cleared through a CCP should be retained in a central contract repository’’). 

These recommendations provide a helpful framework for policymakers and industry alike to discuss while reviewing and reforming the current regulatory structure. 

Of particular importance from ISDA’s perspective is the PWG’s statement acknowledging the continued need for bi-lateral, custom tailored risk management contracts. 

As the PWG states: ‘‘Participants should also be able to bilaterally negotiate customized contracts where there are benefits in doing so, subject to continued oversight by their prudential supervisors.’’ While some have posited that all OTC derivatives contracts should be made to trade on-exchange, as the PWG notes there will 

continue to be the need for customized OTC transactions. 

On the same day the PWG announced its policy objectives, it also released a 

Memorandum of Understanding among the Federal Reserve, the Commodities Futures Trading Commission and the Securities and Exchange Commission related to 

regulation of central counterparties. This Memorandum is an important step in ensuring that regulators do not work at cross-purposes while working to facilitate the 

creation of a central clearinghouse. It would be unfortunate were the creation of a 

CDS clearinghouse to be unnecessarily delayed because of a lack of agreement 

among federal regulators. 

Conclusion 

Both the role and effects of CDS in the current market turmoil have been greatly 

exaggerated. CDS were not the cause, or even a large contributor, to this turmoil. 

There is little dispute that ill advised mortgage lending, coupled with improperly 

understood securities backed by those loans, are the root cause of the present financial problems. These risk management problems have in some instances been exacerbated by a failure to appropriately manage collateral and liquidity. 

CDS are valuable risk management tools. They facilitate lending and corporate 

finance and provide an important price discovery function that is useful not only 

within the CDS business itself but across a much broader spectrum. The business 

has remained open and liquid throughout the financial crisis, demonstrating its resiliency. 

It is ISDA’s hope that the facts surrounding privately negotiated derivatives, including CDS, will highlight the benefit of these risk-transfer tools and the robust, 

sound infrastructure that has developed around them. 

At the same time, recent market events clearly demonstrate that the regulatory 

structure for financial services has failed. Laws and regulations written in the 20th 

century, in many cases designed to address markets which existed in the 18th century, need to be changed to account for 21st century markets and products. An indepth examination of the U.S. regulatory structure is self-evidently warranted. 

In summary, privately negotiated derivatives have continued to perform well during a greater period of stress than the world financial system has witnessed in decades. In the wake of failures of major market participants, both counterparties and 

issuers of debt, CDS participants have settled trades in an orderly way precisely according to the rules and procedures established by Congress and market participants. In this respect CDS activity has been a tremendous success. We are confident 

that policymakers and market participants alike will find their prudent efforts in 

helping build the infrastructure for derivatives over the last 25 years have been rewarded. 

PREPARED STATEMENT OF DAMON A. SILVERS 

ASSOCIATE GENERAL COUNSEL, 

AFL–CIO 

MARCH 10, 2009 

Good morning, Chairman Dodd and Senator Shelby. My name is Damon Silvers, 

I am an Associate General Counsel of the AFL–CIO, and I am the Deputy Chair 

of the Congressional Oversight Panel created under the Emergency Economic Stabilization Act of 2008 to oversee the TARP. While I will describe the Congressional 

Oversight Panel’s report on regulatory reform, my testimony reflects my views and 
134 

1 Congressional Oversight Panel, Special Report on Regulatory Reform, at 3 (Jan. 29, 2009), 

available at http://cop.senate.gov/documents/cop-012909-report-regulatoryreform.pdf 

the views of the AFL–CIO unless otherwise noted, and is not on behalf of the Panel, 

its staff or its chair, Elizabeth Warren. 

The vast majority of American investors participate in the markets as a means 

to secure a comfortable retirement and to send their children to college. Most investors’ goals are long term, and most investors rely on others to manage their money. 

While the boom and bust cycles of the last decade generated fees for Wall Street— 

in many cases astounding fees—they have turned out to have been a disaster for 

most investors. The 10-year nominal rate of return on the S&P 500 is now negative, 

and returns for most other asset classes have turned out to be more correlated with 

U.S. equity markets than anyone would have imagined a decade ago. 

While the spectacular frauds like the Madoff ponzi scheme have generated a great 

deal of publicity, the bigger questions are (1) how did our financial system as a 

whole become so weak how did our system of corporate governance, securities regulation, and disclosure-based market discipline fail to prevent trillions of dollars from 

being invested in value-destroying activities—ranging from subprime mortgages and 

credit cards, to the stocks and bonds of financial institutions, to the credit default 

swaps pegged to those debt instruments; and (2) what changes must be made to 

make our financial system a more reasonable place to invest the hard earned savings of America’s working families? 

My testimony today will seek to answer the second question at three levels: 

1 How should Congress strengthen the regulatory architecture to better protect 

investors; 

2. How should Congress think about designing regulatory jurisdiction to better 

protect investors; and 

3. What are some specific substantive steps Congress and the regulators should 

take to shore up our system of investor protections? 

Finally, I will briefly address how to understand the challenge of investor protection in globalized markets. 

Regulatory Architecture 

While there has been much discussion of the need for better systemic risk regulation, the Congressional Oversight Panel, in its Special Report on Regulatory Reform 

issued on January 29, 2009, observed that addressing issues of systemic risk cannot 

be a substitute for a robust, comprehensive system of routine financial regulation. 1

There are broadly three types of routine regulation in the financial markets—(1) 

safety and soundness regulation for insured institutions like banks and insurance 

companies; (2) disclosure and fiduciary duty regulation for issuers and money managers in the public securities markets; and (3) substantive consumer protection regulation in areas like mortgages, credit cards, and insurance. These are distinct regulatory missions in significant tension with each other. 

Investors, people who seek to put money at risk for the prospect of gains, really 

are interested in transparency, enforcement of fiduciary duties, and corporate governance. This is the investor protection mission. It is often in tension with the 

equally legitimate regulatory mission of protecting the safety and soundness of insured financial institutions. A safety and soundness regulator is likely to be much 

more sympathetic to regulated entities that want to sidestep telling the investing 

public bad news. At the same time, investor protection is not the same thing as consumer protection—the consumer looking for home insurance or a mortgage is seeking to purchase a financial service with minimal risk, not to take a risk in the hope 

of a profit. 

Because these functions should not be combined, investor protection should be the 

focus of a single agency within the broader regulatory framework. That agency 

needs to have the stature and independence to protect the principles of full disclosure by market participants and compliance with fiduciary duties among market 

intermediaries. Any solution to the problem of systemic risk prevention should involve the agency charged with investor protection, and not supersede it. 

Since the New Deal, the primary body charged with enforcing investor protections 

has been the Securities and Exchange Commission. Although the Commission has 

suffered in recent years from diminished jurisdiction and leadership failure, it remains an extraordinary government agency, whose human capital and market expertise needs to be built upon as part of a comprehensive strategy for effective reregulation of the capital markets. 
135 

2Department of the Treasury, Blueprint for a Modernized Financial Regulatory Structure, at 

11-13, 106-126 (Mar. 2008), available at http://www.treas.gov/press/releases/reports/Blueprint.pdf 3 Committee on Capital Markets Regulation, Interim Report (Nov. 30, 2006), available at 

http://www.capmktsreg.org/pdfs/11.30CommitteelInterimlReportREV2.pdf; Committee on 

Capital Markets Regulation, The Competitive Position of the U.S. Public Equity Market (Dec. 

4, 2007), available at http://www.capmktsreg.org/pdfs/ 

ThelCompetitivelPositionloflthelUSlPubliclEquitylMarket.pdf 4Securities Industry and Financial Markets Association, Market Sector Statistics: Asset 

Backed Securities—Outstanding By Major Types of Credit. 5See, e.g., Speech by SEC Chairman: Address to Practising Law Institute’s ‘‘SEC Speaks in 

2009’’ Program available at http://sec.gov/news/speech/2009/spch020609mls.htm 6Senator Barack Obama, Renewing the American Economy, Speech at Cooper Union in New 

York (Mar. 27, 2008) (transcript available at http://www.nytimes.com/2008/03/27/us/politics/ 

27text-obama.html?pagewanted=all); Congressional Oversight Panel, Special Report on Regulatory Reform, at 29. 

While I have a great deal of respect for former Treasury Secretary Paulson, there 

is no question that his blueprint for financial regulatory reform was profoundly deregulatory in respect to the Securities and Exchange Commission. 2 He and others, 

like the self-described Committee on Capital Markets Regulation led by Harvard 

Professor Hal Scott, sought to dismantle the Commission’s culture of arms length, 

enforcement-oriented regulation and to replace it with something frankly more captive to the businesses it regulated. 3 While these deregulatory approaches have fortunately yet to be enacted, they contributed to an environment that weakened the 

Commission politically and demoralized its staff. 

While there has been a great deal of attention paid to the Commission’s failure 

to spot the Madoff ponzi scheme, there has been insufficient attention to the Commission’s performance in relation to the public debt markets, where the SEC regulates more than $438.3 billion in outstanding securities related to home equity loans 

and manufactured housing loans, among the riskiest types of mortgages. Similarly, 

little attention has been paid to the oversight of disclosures by the financial and 

homebuilding firms investing in and trading in those securities, and perhaps most 

importantly, the lack of action by the Commission once the financial crisis began. 4

But elections have consequences, and one of those consequences should be a renewed commitment by both Congress and the new Administration to revitalizing the 

Commission and to rebuilding the Commission’s historic investor protection oriented 

culture and mission. The President’s budget reflects that type of approach in the 

funding it seeks for the Commission, and the new Chair of the Commission Mary 

Schapiro has appeared to be focused on just this task in her recent statements. 5

A key issue the Commission faces is how to strengthen its staff. Much of what 

needs to be done is in the hands of the Commission itself, where the Chair and the 

Commissioners set the tone for better or for worse. When Commissioners place procedural roadblocks in the way of enforcing the law, good people leave the Commission and weak staff are not held accountable. When the Chair sets a tone of vigorous enforcement of the laws and demands a genuine dedication to investor protection, the Commission both attracts and retains quality people. 

Congress should work with the Commission to determine if changes are needed 

to personnel rules to enable the Commission to attract and retain key personnel. 

The Commission should look at more intensive recruiting efforts aimed at more experienced private sector lawyers who may be looking for public service opportunities—perhaps through a special fellows program. On the other hand, Congress 

should work with the Commission to restrict the revolving door—ideally by adopting 

the rule that currently applies to senior bank examiners for senior Commission 

staff—no employment with any firm whose matters the staffer worked on within 12 

months. 

Regulating the Shadow Markets and the Problem of Jurisdiction 

The financial crisis is directly connected to the degeneration of the New Deal system of comprehensive financial regulation into a Swiss cheese regulatory system, 

where the holes, the shadow markets, grew to dominate the regulated markets. If 

we are going to lessen future financial boom and bust cycles, Congress must give 

the regulators the tools and the jurisdiction to regulate the shadow markets. In our 

report of January 29, the Congressional Oversight Panel specifically observed that 

we needed to regulate financial products and institutions, in the words of President 

Obama, ‘‘for what they do, not what they are.’’ 6 We further noted in that report that 

shadow market products and institutions are nothing more than new names and 
136 

7 Congressional Oversight Panel, Special Report on Regulatory Reform, at 29. 

8 Id. 

9 Id. 

10Fin. Planning Ass’n v. SEC, 482 F.3d 481 (D.C. Cir. 2007). 11 Id. at 40-44. 

new legal structures for very old activities like insurance (read credit default swaps) 

and money management (read hedge funds and private equity/lbo funds). 7

The Congressional Oversight Panel’s report stated that shadow institutions 

should be regulated by the same regulators who currently have jurisdiction over 

their regulated counterparts. 8 So, for example, the SEC should have jurisdiction 

over derivatives that are written using public debt or equity securities as their underlying asset. The Congressional Oversight Panel stated that at a minimum, hedge 

funds should also be regulated by the SEC in their roles as money managers by 

being required to register as investment advisors and being subject to clear fiduciary duties, the substantive jurisdiction of U.S. law, and periodic SEC inspections. 9

To the extent a hedge fund or anyone else engages in writing insurance contracts 

or issuing credit, however, it should be regulated by the bodies charged with regulating that type of economic activity. 

Some have suggested having such shadow market financial products as derivatives and hedge funds simply regulated by a systemic regulator. This would be a 

terrible mistake. Shadow market products and institutions need to be brought under 

the same routine regulatory umbrella as other financial actors. To take a specific 

case, while it is a good idea to have public clearinghouses for derivatives trading, 

that reform by itself is insufficient without capital requirements for the issuers of 

derivatives and without disclosure and the application of securities law principles, 

generally, to derivatives based on public securities regulations. So, for example, the 

SEC should require the same disclosure of short positions in public equities that it 

requires of long positions in equities, whether those positions are created through 

the securities themselves or synthetically through derivatives or futures. 

The historic distinctions between broker-dealers and investment advisors have 

been eroding in the markets for years. In 2007, the Federal Appeals Court for the 

District of Columbia issued an opinion overturning Commission regulations seeking 

to better define the boundary between the two. 10 The Commission should look at 

merging the regulation of the categories while ensuring that the new regulatory 

framework preserves clear fiduciary duties to investors. As part of a larger examination of the duties owed by both broker-dealers and investment advisors to investors, 

the Commission ought to examine the fairness and the efficacy of the use of arbitration as a form of dispute resolution by broker-dealers. Finally, part of what must 

be done in this area is to determine whether the proper regulatory approach will 

require Congressional action in light of the D.C. Circuit opinion. 

But there is a larger point here. Financial reregulation will be utterly ineffective 

if it turns into a series of rifle shots at the particular mechanisms used to evade 

regulatory structures in earlier boom and bust cycles. What is needed is a return 

to the jurisdictional philosophy that was embodied in the founding statutes of federal securities regulation—very broad, flexible jurisdiction that allowed the SEC to 

follow the activities. By this principle, the SEC should have jurisdiction over anyone 

over a certain size who manages public securities, and over any contract written 

that references publicly traded securities. Applying this principle would require at 

least shifting the CFTC’s jurisdiction over financial futures to the SEC, if not merging the two agencies under the SEC’s leadership. 

Much regulatory thinking over the last couple of decades has been shaped by the 

idea that sophisticated parties should be allowed to act in financial markets without 

regulatory oversight. Candidly, some investors have been able to participate in a 

number of relatively lightly regulated markets based on this idea. But this idea is 

wrong. Big, reckless sophisticated parties have done a lot of damage to our financial 

system and to our economy. I do not mean to say that sophisticated parties in the 

business of risk taking should be regulated in the same way as auto insurers selling 

to the general public. But there has to be a level of transparency, accountability, 

and mandated risk management across the financial markets. 

Finally, while it is not technically a shadow market, the underregulation of the 

credit rating agencies has turned out to have devastating consequences. The Congressional Oversight Panel called particular attention to the dysfunctional nature of 

the issuer pays model, and recommended a set of options for needed structural 

change—from the creation of PCAOB-type oversight body to the creation of a public 

or non-profit NRSRO. 11
137 

12 Rachelle Younglai, SEC developing proxy access plans: sources, REUTERS, Mar. 6, 2009, 

at http://www.reuters.com/article/bernardMadoff/idUSTRE52609820090307 

13 Congressional Oversight Panel, Special Report on Regulatory Reform, at 37-40. 14 Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994); 

Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761 (2008). 

Substantive Reforms 

Beyond regulating the shadow markets, the Congress and the Securities and Exchange Commission need to act to shape a corporate governance and investor protection regime that is favorable to long term investors and to the channeling of capital to productive purposes. There is no way to look at the wreckage surrounding 

us today in the financial markets and not conclude we have had a regulatory regime 

that, intentionally or not, facilitated grotesquely short-term thinking and led to capital flowing in unheard of proportions to pointless or destructive ends. 

This is a large task, and I will simply point out some of the most important steps 

that need to be taken in three areas—governance, executive pay, and litigation. 

First, in the area of governance, once again the weakness of corporate boards, particularly in the financial sector, appears to be a central theme in the financial scandal. The AFL–CIO has interviewed the audit committees of a number of the major 

banks to better understand what happened. We found in general very weak board 

oversight of risk—evidenced in audit committee leadership who did not understand 

their companies’ risk profiles, and in boards that tolerated the weakening of internal 

risk management. 

Strong boards require meaningful accountability to investors. Short-term, leveraged investors have been the most powerful voices in corporate governance in recent 

years, with destructive results. The AFL–CIO urges Congress to work with the SEC 

to ensure that there are meaningful, useable ways for long-term investors to nominate and elect psychologically independent directors to public company boards 

through access to the corporate proxy. I put the stress here on long-term—there 

must be meaningful holding time requirements for exercising this right. Recent 

statements by SEC Chair Mary Schapiro suggest she is focused on this area, and 

we urge the Congress to support her efforts. 12

Second, effective investor protection requires a comprehensive approach to reform 

in the area of executive pay. Proxy access is an important first step in this area, 

but we should learn from the financial crisis how destructive short-term oriented, 

asymmetric executive pay can be for long-term investors and for our economy. The 

focus of the Congressional Oversight Panel’s recommendations in the area of executive pay were on ending these practices in financial institutions. 13 Here Chairman 

Dodd’s leadership has been very helpful in the context of the TARP. 

But Congress and the Administration should pursue a comprehensive approach to 

executive pay reform around two concepts—equity linked pay should be held beyond 

retirement, and pay packages as a whole should reflect a rough equality of exposure 

to downside risk as to upside gain. Orienting policy in this direction requires coordination between securities regulation and tax policy. But we could begin to address 

what has gone wrong in executive pay incentives by (1) developing measurements 

for both the time horizon and the symmetry of risk and reward of pay packages that 

could be included in pay disclosure; (2) looking more closely at mutual fund proxy 

voting behavior to see if it reflects the time horizons of the funds; (3) focusing 

FINRA inspections of broker dealer pay policies on these two issues; and (4) providing for advisory shareholder votes on pay packages. With respect to say on pay, 

any procedural approaches that strengthened the hand of long term investors in the 

process of setting executive compensation would be beneficial. 

Finally, Congress needs to address the glaring hole in the fabric of investor protection created by the Central Bank of Denver and Stoneridge cases. 14 These cases 

effectively granted immunity from civil liability to investors for parties such as investment banks and law firms that are co-conspirators in securities frauds. It appeared for a time after Enron that the courts were going to restore some sanity in 

this area of the law on their own, by finding a private right of action when service 

providers were actually not just aiders and abetters of a fraud, but actual co-conspirators. In the Stoneridge decision, with the Enron case looming over them, the 

Supreme Court made clear Congress would have to act. The issue here of course 

is not merely fairness to the investors defrauded in a particular case—it is the incentives for financial institutions to police their own conduct. We seem to have had 

a shortage of such incentives in recent years. 

The International Context 

The Bush Administration fundamentally saw the internationalization of financial 

markets as a pretext for weakening U.S. investor protections. That approach has 
138 

been discredited. It needs to be replaced by a commitment on the part of the Obama 

Administration to building a strong global regulatory floor in coordination with the 

world’s other major economies. This effort is vital not only for protecting U.S. investors in global markets, but for protecting our financial sector from the consequences 

of a global regulatory race to the bottom that will inevitably end in the kind of financially driven economic crisis that we are living through today. Congress can play 

a part by seeking to strengthen its relationships with its counterpart legislative bodies in the major world markets, and should look for opportunities to coordinate setting regulatory standards on a global basis. The Administration needs to make this 

effort a priority, and to understand that it needs to extend beyond the narrow confines of systemic risk and the banking system to issues of transparency and investor 

protection. 

However, Congress must not allow the need for global coordination to be an impediment or a prerequisite to vigorous action to reregulate U.S. financial markets 

and institutions. That task is urgent and must be addressed if the U.S. is to recover 

from the blow this financial crisis has delivered to our private capital markets’ reputation as the gold standard for transparency and accountability. 

Conclusion 

The task of protecting investors by reregulating our financial system and restoring vitality to our regulators is a large one. This testimony simply sketches the outline of an approach, and notes some key substantive steps Congress and the Administration need to take. This Committee has already taken a leadership role in a 

number of these areas, but there is much more to be done. Even in areas where 

the primary responsibility must lie with regulators, there is a much needed role for 

Congress to oversee, encourage, and support the efforts of the Administration. 

While I do not speak for the Congressional Oversight Panel, I think I am safe in 

saying that the Panel is honored to have been asked to assist Congress in this effort, and is prepared to assist this Committee in any manner the Committee finds 

useful. I can certainly make that offer on behalf of the AFL–CIO. Thank you. 

SUPPLEMENT—March 10, 2009 

The challenge of addressing systemic risk in the future is one, but by no means 

the only one, of the challenges facing Congress as Congress considers how to reregulate U.S. financial markets following the extraordinary events of the last 18 months. 

Systemic crises in financial markets harm working people. Damaged credit systems destroy jobs rather than create them. Pension funds with investments in panicked markets see their assets deteriorate. And the resulting instability undermines 

business’ ability to plan and obtain financing for new investments—undermining 

the long term growth and competitiveness of employers and setting the stage for future job losses. The AFL–CIO has urged Congress since 2006 to act to reregulate 

shadow financial markets, and the AFL–CIO supports addressing systemic risk, but 

in a manner that does not substitute for strengthening the ongoing day to day regulatory framework, and that recognizes addressing systemic risk both requires regulatory powers and financial resources that can really only be wielded by a fully public body. 

The concept of systemic risk is that financial market actors can create risk not 

just that their institutions or portfolios will fail, but risk that the failure of their 

enterprises will cause a broader failure of other financial institutions, and that such 

a chain of broader failures can jeopardize the functioning of financial markets as 

a whole. The mechanisms by which this broader failure can occur involve a loss of 

confidence in information, or a loss of confidence in market actors ability to understand the meaning of information, which leads to the withdrawal of liquidity from 

markets and market institutions. Because the failure of large financial institutions 

can have these consequence, systemic risk management generally is seen to both be 

about how to determine what to do when a systemically significant institution faces 

failure, and about how to regulated such institutions in advance to minimize the 

chances of systemic crises. 

Historically, the United States has had three approaches to systemic risk. The 

first was prior to the founding of the Federal Reserve system, when there was a 

reluctance at the Federal level to intervene in any respect in the workings of credit 

markets in particular and financial markets in general. The Federal Reserve system, created after the financial collapse of 1907, ushered in an era where the Federal Government’s role in addressing systemic risk largely consisted of sponsoring 

through the Federal Reserve system, a means of providing liquidity to member 

banks, and thus hopefully preventing the ultimate liquidity shortage that results 

from market participants losing confidence in the financial system as a whole. 
139 

But then, after the Crash of 1929 and the 4 years of Depression that followed, 

Congress and the Roosevelt Administration adopted a regulatory regime whose purpose was in a variety of ways to substantively regulate financial markets in an ongoing way. This new approach arose out of a sense among policymakers that the 

systemic financial crisis associated with the Great Depression resulted from the 

interaction of weakly regulated banks with largely unregulated securities markets, 

and that exposing depositors to these risks was a systemic problem in and of itself. 

Such centerpieces of our regulatory landscape as the Securities and Exchange Commission’s disclosure based system of securities regulation and the Federal Deposit 

Insurance Corporation came into being not just as systems for protecting the economic interests of depositors or investors, but as mechanisms for ensuring systemic 

stability by, respectively, walling off bank depositors from broader market risks, and 

ensuring investors in securities markets had the information necessary to make it 

possible for market actors to police firm risk taking and to monitor the risks embedded in particular financial products. 

In recent years, financial activity has moved away from regulated and transparent markets and institutions and into the so-called shadow markets. Regulatory 

barriers like the Glass-Steagall Act that once walled off less risky from more risky 

parts of the financial system have been weakened or dismantled. So we entered the 

recent period of extreme financial instability with an approach to systemic risk that 

looked a lot like that of the period following the creation of the Federal Reserve 

Board but prior to the New Deal era. And so we saw the policy response to the initial phases of the current financial crisis primarily take the form of increasing liquidity into credit markets through interest rate reductions and increasingly liberal 

provision of credit to banks and then to non-bank financial institutions. 

However, with the collapse of Lehman Brothers and the Federal rescues of AIG, 

FNMA, and the FHLMC, the federal response to the perception of systemic risk 

turned toward much more aggressive interventions in an effort to ensure that after 

the collapse of Lehman Brothers, there would be no more defaults by large financial 

institutions. This approach was made somewhat more explicit with the passage of 

the Emergency Economic Stabilization Act of 2008 and the commencement of the 

TARP program. The reality was though that the TARP program was the creature 

of certain very broad passages in the bill, which generally was written with the view 

that the federal government would be embarking on the purchase of troubled assets, 

a very different approach than the direct infusions of equity capital that began with 

the Capital Purchase Program in October of 2008. 

We can now learn some lessons from this experience for the management of systemic risk in the financial system. 

First, our government and other governments around the world will step in when 

major financial institutions face bankruptcy. We do not live in a world of free market discipline when it comes to large financial institutions, and it seems unlikely 

we ever will. If two administrations as different as the Bush Administration and 

the Obama Administration agree that the Federal Government must act when 

major financial institutions fail, it is hard to imagine the administration that would 

do differently. Since the beginning of 2008, we have used Federal dollars in various 

ways to rescue either the debt or the equity holders or both at the following companies—Bear Stearns, Indymac, Washington Mutual, AIG, Merrill Lynch, Fannie Mae, 

Freddie Mac, Citigroup, and Bank of America. But we have no clear governmental 

entity charged with making the decision over which company to rescue and which 

to let fail, no clear criteria for how to make such decisions, and no clear set of tools 

to use in stabilizing those that must be stabilized. 

Second, we appear to be hopelessly confused as to what it means to stabilize a 

troubled financial institution to avoid systemic harm. We have a longstanding system of protecting small depositors in FDIC insured banks, and by the way policyholders in insurance companies through the state guarantee funds. The FDIC has 

a process for dealing with banks that fail—a process that does not always result in 

100 percent recoveries for uninsured creditors. Then we have the steps taken by the 

Treasury Department and the Federal Reserve since Bear Stearns collapsed. At 

some companies, like Fannie Mae and Freddie Mac, those steps have guaranteed 

all creditors, but wiped out the equity holders. At other companies, like Bear 

Stearns, AIG, and Wachovia, while the equity holders survive, they have been massively diluted one way or another. At others, like Citigroup and Bank of America, 

the equity has been only modestly diluted when looked at on an upside basis. It is 

hard to understand exactly what has happened with the government’s interaction 

with Morgan Stanley and Goldman Sachs, but again there has been very little equity dilution. And then there is poor Lehman Brothers, apparently the only non-systemic financial institution, where everybody lost. In crafting a systematic approach 

to systemically significant institutions, we should begin with the understanding that 
140 

while a given financial institution may be systemically significant, not every layer 

of its capital structure should be necessarily propped up with taxpayer funds. 

Third, much regulatory thinking over the last couple of decades has been shaped 

by the idea that sophisticated parties should be allowed to act in financial markets 

without regulatory oversight. But this idea is wrong. Big, reckless sophisticated parties have done a lot of damage to our financial system and to our economy. This 

is not to say that sophisticated parties in the business of risk taking should be regulated in the same way as auto insurers selling to the general public. But there has 

to be a level of transparency, accountability, and mandated risk management across 

the financial markets. 

Fourth, financial markets are global now. Norwegian villages invest in U.S. mortgage backed securities. British bankruptcy laws govern the fate of U.S. clients of 

Lehman Brothers, an institution that appeared to be a U.S. institution. AIG, our 

largest insurance company, collapsed because of a London office that employed 300 

of AIG’s 500,000 employees. Chinese industrial workers riot when U.S. real estate 

prices fall. We increasingly live in a world where the least common denominator in 

financial regulation rules. 

So what lessons should we take away for how to manage systemic risk in our financial system? 

The Congressional Oversight Panel, in its report to Congress made the following 

points about addressing systemic risk: 

1. There should be a body charged with monitoring sources of systemic risk in 

the financial system, but it could either be a new body, an existing agency, or 

a group of existing agencies; 

2. The body charged with systemic risk managements should be fully accountable 

and transparent to the public in a manner that exceeds the general accountability mechanisms present in self-regulatory organizations; 

3. We should not identify specific institutions in advance as too big to fail, but 

rather have a regulatory framework in which institutions have higher capital 

requirements and pay more on insurance funds on a percentage basis than 

smaller institutions which are less likely to be rescued as being too systemic 

to fail. 

4. Systemic risk regulation cannot be a substitute for routine disclosure, accountability, safety and soundness, and consumer protection regulation of financial 

institutions and financial markets. 

5. Ironically, effective protection against systemic risk requires that the shadow 

capital markets—institutions like hedge funds and products like credit derivatives—must not only be subject to systemic risk oriented oversight but must 

also be brought within a framework of routine capital market regulation by 

agencies like the Securities and Exchange Commisson. 

6. There are some specific problems in the regulation of financial markets, such 

as the issue of the incentives built into executive compensation plans and the 

conflict of interest inherent in the credit rating agencies’ business model of 

issuer pays, that need to be addressed to have a larger market environment 

where systemic risk is well managed. 

7. Finally, there will not be effective reregulation of the financial markets without 

a global regulatory floor. 

I would like to explain some of these principles and at least the thinking I 

brought to them. First, on the issue of a systemic risk monitor, while the Panel 

made no recommendation, I have come to believe that the best approach is a body 

with its own staff and a board made up of the key regulators, perhaps chaired by 

the Chairman of the Board of Governors of the Federal Reserve. There are several 

reasons for this conclusion. First, this body must have as much access as possible 

to all information extant about the condition of the financial markets—including not 

just bank credit markets, but securities and commodities, and futures markets, and 

consumer credit markets. As long as we have the fragmented bank regulatory system we now have, this body would need access to information about the state of all 

deposit taking institutions. The reality of the interagency environment is that for 

information to flow freely, all the agencies involved need some level of involvement 

with the agency seeking the information. Connected with the information sharing 

issue is expertise. It is unlikely a systemic risk regulator would develop deep enough 

expertise on its own in all the possible relevant areas of financial activity. To be 

effective it would need to cooperate in the most serious way possible with all the 

routine regulators where the relevant expertise would be resident. 
141 

Second, this coordinating body must be fully public. While many have argued the 

need for this body to be fully public in the hope that would make for a more effective regulatory culture, the TARP experience highlights a much more bright line 

problem. An effective systemic risk regulator must have the power to bail out institutions, and the experience of the last year is that liquidity provision is simply not 

enough in a real crisis. An organization that has the power to expend public funds 

to rescue private institutions must be a public organization—though it should be insulated from politics much as our other financial regulatory bodies are by independent agency structures. 

Here is where the question of the role of the Federal Reserve comes in. A number 

of commentators and Fed officials have pointed out that the Fed has to be involved 

in any body with rescue powers because any rescue would be mounted with the 

Fed’s money. However, the TARP experience suggests this is a serious oversimplification. While the Fed can offer liquidity, many actual bailouts require equity 

infusions, which the Fed cannot currently make, nor should it be able to, as long 

as the Fed continues to seek to exist as a not entirely public institution. In particular, the very bank holding companies the Fed regulates are involved in the governance of the regional Federal Reserve Banks that are responsible for carrying out 

the regulatory mission of the Fed, and would if the current structure were untouched, be involved in deciding which member banks or bank holding companies 

would receive taxpayer funds in a crisis. 

These considerations also point out the tensions that exist between the Board of 

Governors of the Federal Reserve System’s role as central banker, and the great importance of distance from the political process, and the necessity of political accountability and oversight once a body is charged with dispersing the public’s money to 

private companies that are in trouble. That function must be executed publicly, and 

with clear oversight, or else there will be inevitable suspicions of favoritism that will 

be harmful to the political underpinnings of any stabilization effort. One benefit of 

a more collective approach to systemic risk monitoring is that the Federal Reserve 

Board could participate in such a body while having to do much less restructuring 

that would likely be problematic in terms of its monetary policy activity. 

On the issue of whether to identify and separately regulate systemically significant firms, another lesson of the last eighteen months is that the decision as to 

whether some or all of the investors and creditors of a financial firm must be rescued cannot be made in advance. In markets that are weak or panicked, a firm that 

was otherwise seen as not presenting a threat of systemic contagion might be seen 

as doing just that. Conversely, in a calm market environment, it maybe the better 

course of action to let a troubled firm go bankrupt even if it is fairly large. Identifying firms (ITAL)ex ante as systemically significant also makes the moral hazard 

problems much more intense. 

An area the Congressional Oversight Panel did not address explicitly is whether 

effective systemic risk management in a world of diversified institutions would require some type of universal systemic risk insurance program or tax. Such a program would appear to be necessary to the extent the federal government is accepting it may be in a position of rescuing financial institutions in the future. Such a 

program would be necessary both to cover the costs of such interventions and to balance the moral hazard issues associated with systemic risk management. However, 

there are practical problems defining what such a program would look like, who 

would be covered and how to set premiums. One approach would be to use a financial transactions tax as an approximation. The global labor movement has indicated 

its interest in such a tax on a global basis, in part to help fund global reregulation 

of financial markets. 

More broadly, these issues return us to the question of whether the dismantling 

of the approach to systemic risk embodied in the Glass-Steagall Act was a mistake. 

We would appear now to be in a position where we cannot wall off more risky activities from less risky liabilities like demand deposits or commercial paper that we 

wish to ensure. On the other hand, it seems mistaken to try and make large securities firms behave as if they were commercial banks. Those who want to maintain 

the current dominance of integrated bank holding companies in the securities business should have some burden of explaining how their securities businesses plan to 

act now that they have an implicit government guaranty. 

Finally, the AFL–CIO believes very strongly that the regulation of the shadow 

markets, and of the capital markets as a whole cannot be shoved into the category 

labeled ‘‘systemic risk regulation,’’ and then have that category be effectively a sort 

of night watchman effort. The lesson of the failure of the Federal Reserve to use 

its consumer protection powers to address the rampant abuses in the mortgage industry earlier in this decade is just one of several examples going to the point that 

without effective routine regulation of financial markets, efforts to minimize the risk 
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of further systemic breakdowns are unlikely to succeed. We even more particularly 

oppose this type of formulation that then hands responsibility in the area of systemic risk regulation over to self-regulatory bodies. 

As Congress moves forward to address systemic risk management, one area that 

we believe deserves careful consideration is how much power to give to a body 

charged with systemic risk management to intervene in routine regulatory policies 

and practices. We strongly agree with Professor Coffee’s testimony that a systemic 

risk regulator should not have the power to override investor or consumer protections. However, there are a range of options, ranging from power so broad it would 

amount to creating a single financial services superregulator, e.g., vesting such 

power in staff or a board chairman acting in an executive capacity, to arrangements 

requiring votes or supermajorities, to a system where the systemic risk regulator 

is more of scout than a real regulator, limited in its power to making recommendations to the larger regulatory community. The AFL–CIO would tend to favor a 

choice somewhere more in the middle of that continuum, but we think this is an 

area where further study might help policymakers formulate a well-founded approach. 

Finally, with respect to the jurisdiction and the reach of a systemic risk regulator, 

we believe it must not be confined to institutions per se, or products or markets, 

but must extend to all financial activity. 

In conclusion, the Congressional Oversight Panel’s report lays out some basic 

principles that as a Panel member I hope will be of use to this Committee and to 

Congress in thinking through the challenges involved in rebuilding a more comprehensive approach to systemic risk. The AFL–CIO is very concerned that as Congress approaches the issue of systemic risk it does so in a way that bolsters a broader reregulation of our financial markets, and does not become an excuse for not engaging in that needed broader reregulation. 

AFL–CIO Executive Council Statement—Miami, Florida—March 5, 2009 

Bank Bailouts 

There has been a dramatic concentration of banking power since the GrammLeach-Bliley Act repealed New Deal bank regulation. More than 43 percent of U.S. 

bank assets are held by just four institutions: Citigroup, Bank of America, Wells 

Fargo and JPMorgan Chase. When these institutions are paralyzed, our whole economy suffers. When banks appear on the brink of collapse, as several have repeatedly 

since September, government steps in. The free market rules that workers live by 

do not apply to these banks. 

Since Congress passed financial bailout legislation in October, working people 

have seen our tax dollars spent in increasingly secretive ways to prop up banks that 

we are told are healthy, until they need an urgent bailout. In some instances, institutions that were bailed out need another lifeline soon after. The Congressional 

Oversight Panel, charged with overseeing the bailout, recently found that the Federal Government overpaid by $78 billion in acquiring bank stock. 

The AFL–CIO believes government must intervene when systemically significant 

financial institutions are on the brink of collapse. However, government interventions must be structured to protect the public interest, and not merely rescue executives or wealthy investors. This is an issue of both fairness and our national interest. It makes no sense for the public to borrow trillions of dollars to rescue investors 

who can afford the losses associated with failed banks. 

The most important goal of government support must be to get banks lending 

again by ensuring they are properly capitalized. This requires forcing banks to acknowledge their real losses. By feeding the banks public money in fits and starts, 

and asking little or nothing in the way of sacrifice, we are going down the path 

Japan took in the 1990s—a path that leads to ‘‘zombie banks’’ and long-term economic stagnation. 

The AFL–CIO calls on the Obama administration to get fair value for any more 

public money put into the banks. In the case of distressed banks, this means the 

government will end up with a controlling share of common stock. The government 

should use that stake to force a cleanup of the banks’ balance sheets. The result 

should be banks that can either be turned over to bondholders in exchange for bondholder concessions or sold back into the public markets. We believe the debate over 

nationalization is delaying the inevitable bank restructuring, which is something 

our economy cannot afford. 

A government conservatorship of the banks has been endorsed by leading economists, including Nouriel Roubini, Joseph Stiglitz, and Paul Krugman. Even Alan 

Greenspan has stated it will probably be necessary. 

The consequences of crippled megabanks are extraordinarily serious. The resulting credit paralysis affects every segment of our economy and society and destroys 
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jobs. We urge President Obama and his team to bring the same bold leadership to 

bear on this problem as they have to the problems of economic stimulus and the 

mortgage crisis. 

AFL–CIO Executive Council Statement—Miami, Florida—March 5, 2009 

Financial Regulation 

Deregulated financial markets have taken a terrible toll on America’s working 

families. Whether measured in lost jobs and homes, lower earnings, eroding retirement security, or devastated communities, workers have paid the price for Wall 

Street’s greed. But in reality, the cost of deregulation and financial alchemy are far 

higher. The lasting damage is in missed opportunities and investments not made 

in the real economy. While money poured into exotic mortgage-backed securities and 

hedge funds, our pressing need for investments in clean energy, infrastructure, education, and health care went unmet. 

So the challenge of reregulating our financial markets, like the challenge of restoring workers’ rights in the workplace, is central to securing the economic future 

of our country and the world. In 2006, while the Bush administration was in the 

midst of plans for further deregulation, the AFL–CIO warned of the dangers of unregulated, leveraged finance. That call went unheeded as the financial catastrophe 

gathered momentum in 2007 and 2008, and now a different day is upon us. The 

costs of the deregulation illusion have become clear to all but a handful of unrepentant ideologues, and the public cast its votes in November for candidates who promised to end the era of rampant financial speculation and deregulation. In October, when Congress authorized the $700 billion financial bailout, it also 

established an Oversight Panel to both monitor the bailout and make recommendations on financial regulatory reform. The panel’s report lays the foundation for what 

Congress and the Obama administration must do. 

First, we must recognize that financial regulation has three distinct purposes: (1) 

ensuring the safety and soundness of insured, regulated institutions; (2) promoting 

transparency in financial markets; and (3) guaranteeing fair dealing in financial 

markets, so investors and consumers are not exploited. In short, no gambling with 

public money, no lying and no stealing. 

To achieve these goals, we need regulatory agencies with focused missions. We 

must have a revitalized Securities and Exchange Commission (SEC), with the jurisdiction to regulate hedge funds, derivatives, private equity, and any new investment 

vehicles that are developed. The Commodity Futures Trading Commission should be 

merged with the SEC to end regulatory arbitrage in investor protection. 

Second, we must have an agency focused on protecting consumers of financial 

services, such as mortgages and credit cards. We have paid a terrible price for treating consumer protection as an afterthought in bank regulation. 

Third, we need to reduce regulatory arbitrage in bank regulation. At a minimum, 

the Office of Thrift Supervision, the regulator of choice for bankrupt subprime lenders such as Washington Mutual and IndyMac, should be consolidated with other federal bank regulators. 

Fourth, financial stability must be a critical goal of financial regulation. This is 

what is meant by creating a systemic risk regulator. Such a regulator must be a 

fully public agency, and it must be able to draw upon the information and expertise 

of the entire regulatory system. While the Federal Reserve Board of Governors must 

be involved in this process, it cannot undertake it on its own. 

We must have routine regulation of the shadow capital markets. Hedge funds, derivatives, and private equity are nothing new—they are just devices for managing 

money, selling insurance and securities, and engaging in the credit markets without 

being subject to regulation. As President Obama said during the campaign, ‘‘We 

need to regulate institutions for what they do, not what they are.’’ Shadow market 

institutions and products must be subject to transparency and capital requirements 

and fiduciary duties befitting what they are actually doing. 

Reform also is required in the incentives governing key market actors around executive pay and credit rating agencies. There must be accountability for this disaster in the form of clawbacks for pay awarded during the bubble. According to 

Bloomberg, the five largest investment banks handed out $145 billion in bonuses 

in the 5 years preceding the crash, a larger amount than the GDP of Pakistan and 

Egypt. 

Congress and the administration must make real President Obama’s commitment 

to end short-termism and pay without regard to risk in financial institutions. The 

AFL–CIO recently joined with the Chamber of Commerce and the Business Roundtable in endorsing the Aspen Principles on Long-Term Value Creation that call for 

executives to hold stock-based pay until after retirement. Those principles must be 

embodied in the regulation of financial institutions. We strongly support the new 
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SEC chair’s effort to address the role played by weak boards and CEO compensation 

in the financial collapse. With regard to credit rating agencies, Congress must end 

the model where the issuer pays. 

Financial reregulation must be global to address the continuing fallout from deregulation. The AFL–CIO urges the Obama administration to make a strong and 

enforceable global regulatory floor a diplomatic priority, beginning with the G-20 

meeting in April. The AFL–CIO has worked closely with the European Trade Union 

Congress and the International Trade Union Confederation in ensuring that workers are represented in this process. We commend President Obama for convening 

the President’s Economic Recovery Advisory Board, chaired by former Federal Reserve Chair Paul Volcker, author of the G-30 report on global financial regulation, 

and we look forward to working with Chairman Volcker in this vital area. 

Reregulation requires statutory change, regulatory change, institutional reconstruction and diplomatic efforts. The challenge is great, but it must be addressed, 

even as we move forward to restore workers’ rights and revive the economy more 

broadly. 

PREPARED STATEMENT OF THOMAS DOE 

CHIEF EXECUTIVE OFFICER, 

MUNICIPAL MARKET ADVISORS

MARCH 10, 2009 

Introduction 

Chairman Dodd, Senator Shelby and Committee Members: It is a distinct pleasure that I come before you today to share my perspective on the U.S. municipal 

bond industry. I am Thomas Doe, founder and CEO of Municipal Market Advisors, 

that for the past 15 years has been the leading independent research and data provider to the industry. 

In addition from 2003 to 2005, I served as a public member of the Municipal Securities Rulemaking Board (MSRB), the selfregulatory organization (SRO) of the industry established by Congress in 1975. 

The Market 

There are nearly 65,000 issuers in the municipal market that are predominantly states and local governments. Recent figures identify an estimated $2.7 trillion in 

outstanding municipal debt. This is debt that aids our communities in meeting 

budgets and financing society’s essential needs, whether it is building a hospital, 

constructing a school, ensuring clean drinking water, or sustaining the safety of 

America’s infrastructure. A distinctive characteristic of the municipal market is that 

many of those who borrow funds, rural counties and small towns, are only infrequently engaged in the capital markets. 

As a result, there are many issuers of debt who are inexperienced when entering 

a transaction, and unable to monitor deals that may involve the movement of interest rates or the value of derivative products. 

The Growth 

According to the The Bond Buyer, the industry’s trade newspaper, annual municipal bond issuance was $29B in 1975 whereas in 2007 issuance peaked at $430B. 

In the past 10 years derivatives have proliferated as a standard liability management tool for many local governments. However, because derivatives are not regulated it is exceptionally difficult, if not impossible, to identify the degree of systemic, 

as well as specific, risk to small towns and counties that have engaged in complex 

swaps and derivative transactions. 

Systemic Risk Emerges 

Municipal issuers themselves sought to reduce their borrowing costs by selling 

bonds with a floating rate of interest, such as auction-rate securities. Because state 

and local governments do not themselves have revenues that vary greatly with interest rates, these issuers employed interest rate swaps to hedge their risk. Issuers 

used the instruments to transform their floating risk for a fixed-rate obligation. 

A key factor in the growth of the leverage and derivative structures was the prolific use of bond insurance. 

The Penal Rating Scale 

Municipal issuers are rated along a conservative ratings scale, resulting in much 

lower ratings for school districts and states than for private sector financial or insurance companies. Although most state and local governments represent very little 
145 

default risk to the investor, the penal ratings scale encouraged the use of insurance 

for both cash and derivatives to distribute products to investors and facilitate issuer 

borrowing. 

So instead of requiring more accurate ratings, the municipal industry chose to use 

bond insurance to enhance an issuer’s lower credit rating to that of the higher insurance company’s rating. 

The last 18 months have exposed the risks of this choice when insurance company 

downgrades, and auction-rate security failures, forced numerous leveraged investors 

to unwind massive amounts of debt into an illiquid secondary market. The consequence was that issuers of new debt were forced to pay extremely high interest 

rates and investors were confused by volatile evaluations of their investments. 

Steps To Improve the Regulatory Context 

The 34-year era of the municipal industry’s self regulation must come to an end. 

Today, the market would be in a much better place if: First, the regulator were 

independent of the financial institutions that create the products and facilitate 

issuers’ borrowing. 

Second, the regulator were integrated into the national regime of regulation. 

Third, the regulator’s reach and authority were extended to all financial tools and 

participants of the municipal transaction: ratings agencies, insurers, evaluators, and 

investment and legal advisors for both the cash and swaps transactions. 

Fourth, the regulator were charged with more aggressively monitoring market 

data with consumers’ interests in mind, both investors and issuers. 

The good news is that this new era of regulatory oversight can be funded by the MSRB’s annual revenue $20-plus million, collected from bond transactions, and can 

be staffed by the current MSRB policy and administrative infrastructure. 

Caution 

I should be clear. The innovations of derivatives and swaps have a useful application and have been beneficial for those for which they are appropriate. However, it 

is also important that these instruments become transparent and regulated with the 

same care as the corresponding cash market. 

Get This Done 

It is critical to get this right. There is too much at stake. 

Thank you for asking me to testify today, and I welcome your questions during 

this session. 

Municipal Market Advisors 

Founded in 1995, MMA is the leading independent strategy, research and advisory firm in the municipal bond industry. MMA’s intelligent approach to timely 

issues and analysis of market events has proven invaluable to a wide range of clients. As conditions have become more complex and difficult, MMA’s recognized ability to concisely comment on the key issues of the market is of critical importance 

and value. The firm’s independent research, data, market coverage and insight educate and inform without bias or product agenda. 

Our Clients: Investors, Dealers, Financial Advisors, Issuers and Individuals: 

MMA’s business has been predominantly portfolio managers and dealer firms (with 

a focus on sales, trading and underwriting). However, in 2007, demand for our services expanded to include issuers, financial advisors, individuals and public finance 

professionals who have recognized the increased value of accurate and insightful 

coverage of current historical market conditions. MMA does not advocate on behalf 

of its clients, we educate on behalf of the market. 

Washington, DC—Educating and Working With Decision-Makers: MMA’s Washington DC office has enabled our firm to provide more direct information to policy 

makers, regulators, trade associations and the Federal Reserve. MMA’s role is that 

of an educator to provide immediate uncompromised assistance to entities that are 

actively engaged in working on issues pertaining to the municipal industry. 

Informing the Media: In 2008, more than 200 publications and media outlets have 

sought MMA’s expertise for definitive comment on the issues confronting the industry. At no other time has accurate market coverage been more valued, and trusted 

resources considered indispensable. Unbiased information is important for correct 

representation of market conditions, policy decisions and management of portfolios. 

Thomas G. Doe, Founder and CEO: Mr. Doe has been an analyst in the municipal 

industry for 25 years with a consistent focus on pricing data and information flows, 

investor and issuer behavior, and contextual investing. He has addressed all of the 

leading groups in the municipal industry, as Mr. Doe’s insight, candor and historical 

context is sought to establish a clear perspective of current conditions affecting investors and issuers in the municipal cash and derivative markets. He has been a 
146 

featured speaker at numerous industry conferences and has been frequently quoted 

in industry and national media. Mr. Doe’s leadership was recognized when he was 

named to a 3-year term with the Municipal Securities Rulemaking Board, (MSRB) 

the regulatory entity of the municipal securities industry in 2002. Mr. Doe received 

an undergraduate degree from Colgate University in 1980 and a Masters degree 

from Harvard University in 1984. 

Background on How the Credit Crisis Has Affected the Municipal Market 

The municipal market has suffered repeated shocks from the credit crisis since 

August 2007. In a very primary sense, our sector was, and in many ways continues 

to be, exposed to the same systemic risks that collapsed the housing and 

securitization markets and undermined our nation’s banks. The deep interconnectedness of the municipal market with the global financial and interest rate markets 

was unforeseen by most municipal regulators, issuers, investors, advisors, lawyers, 

and dealer banks; their surprise at, and misunderstanding of, the systemic risks at 

work has consistently exacerbated problems over the last two years. Further, there 

is little provision being made at present to create a more resilient and stable market 

in the future. 

The initiation of the credit crisis in municipals, as it was elsewhere, began in 

2001 and 2002, with the integration of leverage into municipal bond buying strategies. Leveraged investment vehicles, called Tender Option Bond (TOB) programs, 

borrowed low interest (floating-rate) cash from the tax-exempt money market funds 

to invest in higher yielding (fixed-rate) municipals. Not only does this strategy capture the simple difference between the high long and low short interest rates (the 

carry), but also TOB sponsors—which included hedge funds, dealer banks, mutual 

funds, liquidity providers, and many others—are placing bets on the tax-exempt 

market’s outperformance of carefully selected taxable bonds or swaps via interest 

rate hedging. 

However, one of the key conditions for the safe operation of a TOB was not implicit in the municipal market: liquidity. Because TOBs are subject to mark-to-market accounting, margin calls, and periodic adjustments of their leverage, they benefit from a well-traded and accurately priced bond market. A TOB invested in securities with unpredictable or volatile prices will itself provide unpredictable and volatile returns. The municipal bond market, as we have detailed elsewhere in this report, comprises 65,000 potential bond issuers and 1.5 million individual securities, 

most of which are rated along an overly cautious rating scale that intentionally exaggerates the risks and differences between individual issuers and bonds. Further, 

municipal issuers have long sold bonds in serial maturities, with a variety of interest rate coupons, call structures, security pledges, etc. And finally, the bulk of municipal investors are households, who either directly or indirectly though a manager, 

prefer to buy and hold small pieces of multiple bond offerings: these are not active 

securities trading operations. 

This context was not conducive for TOBs, but, because their use of leverage they 

were permitted to purchase municipal bonds at substantially higher prices than 

other investors were willing to pay, so the primary market rapidly adjusted to their 

needs. This entailed the pervasive use of AAA-rated bond insurance and bank guaranties (creating the appearance of safe homogeneity) and the facilitation of very 

large, governmental-oriented bond sales carrying a standardized 5 percent coupon. 

For the period between 2002 and 2007, these adjustments permitted the near doubling of annual bond issuance (from about $200Bn to about $400Bn), and the 

amount of par volume municipal bonds outstanding swelled 77 percent from $1.5T 

in 2001 to $2.7T today. What’s more, the rapid growth of TOB (and related strategy) 

investment—along with a large increase in demand from property casualty insurance companies riding post-9/11 waves of premiums and profitability—allowed municipals to be priced more and more aggressively, fulfilling the TOB investor’s aim 

of outperformance of the taxable bond market and encouraging ever larger allocations to this strategy. 

At the same time, the interest rates that tax-exempt money market funds were 

receiving from the TOBs were better than an investor could receive in a regular savings account, and aggressive TOB creation meant a surfeit of product in which the 

money funds could invest. This attracted more money fund deposits which, along 

with monetary policy, kept short-term interest rates low. Municipal issuers themselves sought to reduce their borrowing costs by selling long maturity, AAA-insured 

bonds with a floating rate of interest, including variable-rate demand obligations 

(VRDOs), which can be purchased by the money market funds, and auction-rate securities, which were largely bought by individuals and corporate cash managers. 

However, because state and local governments do not themselves receive much revenue that floats with short-term interest rates, these issuers also employed interest 
147 

rate swaps with these floating-rate bonds in an attempt to exchange their floatingrate liability for a fixed one (but with the addition of increased counterparty exposure to both a bank and the a bond insurer). 

By these means, issuer interest rate swaps and derivatives became a fundamental, but unregulated part of the municipal industry’s standard machinery, and 

systemic exposure to the financial sector, the bond insurers, and, more importantly, 

the rating agencies’ opinions of the financial sector, and the bond insurers grew rapidly. In addition, our market had become substantially vulnerable to fluctuations in 

the value of taxable securities: remember that much if not all of the massive investment by TOBs (estimated to have peaked near $500Bn although little was done by 

the municipal regulators to even tabulate this exposure) was hedged against the 

performance of Treasuries, LIBOR swaps, or other slightly more muni-centric derivatives. 

The problems with this arrangement were exposed in August 2007 with the first 

surge of flight-to-safety buying of Treasury securities on news of worsening damage 

to the housing sector. Stronger Treasury (and LIBOR) prices created losses in TOB 

hedges, forcing margin calls that rapidly consumed available cash. In addition, 

sharp increases in the overnight lending rates pushed floating-rate product credit 

spreads wider: the source of TOB leverage, loans from the money funds, grew much 

more expensive, to the point where the money funds were demanding almost as 

much (or more) interest than the TOBs were receiving from their long-term, fixedrate municipal position. Some TOBs thus began to liquidate their positions, forcing 

sales of their fixed-rate bonds into a municipal secondary market that quickly became oversupplied and illiquid. Keep in mind that, up until that point, the TOBs 

had been purchasing bonds at (and driving market clearing prices and statement 

evaluations to) higher levels than traditional institutional investors were reasonably 

willing to pay. Thus, when the TOBs needed to quickly sell their bonds to these 

same traditional buyers, large price concessions were required. Dealer banks helped 

soften the effects by acquiring bonds into their own trading inventories, but ultimately market pressures forced municipal bond yields sharply higher (while Treasury yields were moving sharply lower). Higher yields attracted enough demand to 

stabilize the market by the end of the month, but, through the end of the year, nervous investors repeated this pattern of fast selling/recovery, heightening volatility in 

prices, and encouraging a steady reduction in TOB investment. For substantially 

more detail on the daily and weekly evolution of our the market, please see the complete catalog of published MMA research, available to subscribers on our Web site 

and to Congressional staffs on request. 

Importantly, market participants had by this time also become increasingly concerned about the future of the bond insurers, who had guaranteed subprime residential mortgage securitizations. Research firms such as MMA and private investors 

amplified former warnings about these companies. In particular, more cautious corporate cash managers began selling auction-rate securities that had been marketed 

to them, in part, based on the apparent safety of AAA-rated bond insurance. Once 

again, dealer banks managing auction-rate programs provided liquidity in the absence of incremental investor demand, but in December 2007, the rating agencies 

sounded formal warnings about the bond insurers. This precipitated vast selling 

pressure among auction-rate investors that, in January, overwhelmed dealers’ risk 

tolerances for buying back additional auction paper, and auctions began to fail 

(please see Auction Rate Securities, below). 

Auction-rate securities paying high penalty rates attracted investors away from 

other fixed- and floating-rate products, forcing both fixed and floating rates up 

sharply. At the end of February 2008, TOB programs were once again forced to sell 

bonds to pay margin calls, to unwind their leverage that had grown too expensive, 

and to afford investor redemptions. Extreme selling and uncertainty led to widely 

divergent pricing decisions across the industry; liquidity was almost completely interrupted, and state and local issuers were temporarily shut out of the capital markets. 

Once again, high yields galvanized demand in March, and from that point until 

December 2008, the municipal market continued to face boom and bust pricing cycles of sometimes extraordinary depth. In general, these entailed yield-fueled, or 

media-driven demand bubbles that were ultimately pricked by yet another bond insurer downgrade that renewed fears and sometimes forced selling by leveraged 

bondholders. The worst of these cycles began in September, when the collapse of 

Lehman Brothers, plus concerns over other broker-dealer counterparties were realized in investor redemptions from municipal money markets, which put large numbers of variable rate obligations back to dealers. The flow of bonds initially overwhelmed dealer balance sheets, forcing the unwind of some proprietary positions, 

but was ultimately managed through dramatically higher floating rates (the munic-
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ipal industry’s 7-day floating rate reset from about 2 percent to 8 percent and credit 

spreads to that rate widened sharply, in particular for TOBs because of their reliance on multiple layers of bank support) and the temporary withdrawal of a large 

number of floaters from active markets onto liquidity provider balance sheets. Still, 

higher floating rates forced many tender option bond programs to unwind their 

trades for perhaps the final time, as investors now began demanding their money 

back in earnest. 

The excess supply created by forced TOB selling in September to November, along 

with downgrades to the bond insurers, pushed municipal yields sharply higher, 

prices lower. Institutional buyers retreated from the public markets until the end 

of the year (although many large buyers were able to buy portfolios of highly discounted bonds in the evenings and weekends, muffling the implications of these 

very cheap trades on broader market pricing), causing credit spreads to widen dramatically. Spread widening and price declines hurt tax-exempt mutual fund net 

asset values, giving the appearance of undue credit risk to their investors and initiating perhaps the largest sequence of mutual fund investor outflows (and thus 

forced selling of related holdings by the funds) on record. And, as was well covered 

by the media, with fixed-rate yields having risen to extraordinary heights, many 

state and local issuers chose to table the majority of their planned primary market 

loans, waiting for conditions to improve. Indeed, smaller, lower-rated, and riskier 

credit issuers may have at least temporarily been unable to access capital at all, 

but large states and cities were always able to raise money; their decisions were 

based on price. MMA estimates that, in 2008, more than $100Bn of planned newmoney infrastructure projects were delayed, the majority of that occurring in the 

fourth quarter. 

Persistent institutional demand has not yet returned to the municipal market, but 

since the start of 2009, municipal fund managers and brokerages have been highly 

successful attracting retail investment on the back of both flight-to-safety allocations 

(out of equities) and, more importantly, on speculation that the stimulus will ultimately drive up municipal bond prices. In fact, yields on the kind of bonds favored 

by retail investors touched two-decade lows in mid-January, although they have 

since begun to retreat again. Lower-rated, risky credit issuers (like hospitals) still 

face difficulty finding cost-effective market access and even highly rated state and 

local governments are commonly required to downsize new bond issues or risk pushing market yields higher. 

Summary of Regulation Issues 

Introduction 

The Municipal Securities Rule-making Board (MSRB) is a self-regulatory organization (SRO) and was formulated by Congressional statute in 1975. Please see the 

attached National Federation of Municipal Analysts White Paper‘‘Federal Securities 

Law Relating to Municipal Securities,’’ for background and more detail. 

During Thomas Doe’s tenure as a Board member from 2003 to 2005, there was 

rarely a Board meeting where the subject of derivatives was not discussed and the 

risks to the industry and investors were not addressed. However, the outdated statute limited the Board’s regulatory purview to municipal cash securities and to activities of dealers and dealer banks. Proactive action was inhibited for three reasons: 

(1) it was exceptionally difficult, however well intended, for Board members representing security firms to advocate for change that would reduce the revenue of 

its firm; (2) the volunteer nature of the Board resulted in a consistent deferral of 

strategy, tactics and policy to staff; (3) the Chairman of the Board served only one 

year and dictated the Board’s focus, which, in our opinion, was to sustain the status 

quo and could again be heavily influence by staff. Since staff, especially the Executive Director, worked for the Board, it appeared to be exceptionally difficult for innovation and proactive regulation to occur. 

To be fair, there is now new leadership of the MSRB’s staff. However, the negative characteristics of a: (1) short-tenured Chairman; (2) volunteer Board; and (3) 

the tremendous challenge to advocate for the investor or issuer interest, which could 

hurt an employer’s revenue stream, are still present. These conditions can be inhibitive toward regulation in the best interest of the consumer—both issuers and investors. 

Opportunity 

In 2009, led by the catalysts of curtailed institutional demand, limited issuer access to the capital markets and the allegations revolving around municipal finance 

practices in New Mexico, the MSRB has suggested a review of the Congressional 

regulatory statute created 34 years ago. Specifically the Board has suggested an ex-
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pansion of entities to be regulated swap advisors. The willingness of the Board to 

advocate change is applauded however, the action falls short. 

Necessary Change 

More entities should not alone be regulated, but rather legislative language 

should be expanded to be inclusive of all practices and products in which financial 

institutions would be involved related to municipal finance. By regulating the products, all entities involved with municipal finance—from creation to distribution— 

would be governed by transparency and regulations, which would advance and define a context for transactions in the municipal industry for the protection of issuer, 

dealer and investor. Only in this manner can responsibility and integrity be promoted and transparency ensured. The byproduct of such attention to derivatives 

would accomplish the disclosure required by issuers to both inform investors and 

those who choose to provide capital to public entities. 

Action Items 

1. End the MSRB as an SRO. 

2. Integrate the MSRB formally and directly into a larger entity, possibly the Securities Exchange Commission, Treasury or Federal Reserve. 

3. Congress expand the regulatory purview of municipal regulation to include all 

participants in municipal finance and all financial tools involved in a municipal 

finance transaction—this would include derivatives and swaps in addition to 

the cash market. Along with dealers: advisors, ratings agencies, and evaluation 

services would be included in the new regulatory scheme. 

4. Ensure that the regulatory statue was adaptable and flexible to allow regulation to be proactive and timely. 

5. Include the municipal industry within an organization, where its regulatory 

framework, data and action can be more easily coordinated with larger markets. (Too often critical regulation may not have been enacted or suggested as 

the industry is small relative to equities and taxable fixed-income. One might 

argue that the vulnerability of the eclectic resources of the 65,000 municipal 

issuers/borrowers of the industry demands more vigilant protection because of 

the critical importance of the financings to essential services and projects for 

town, counties and states in the US.) 

6. Mandate better regulatory coordination with its consumers—specifically issuers 

and investors—not simply the dealer community. 

7. Demand greater financial forensics to mine the vast municipal transaction data 

created by the Real-Time Transaction Reporting System in order to better 

indentify market behavior that can adversely impact (i.e., volatility) issuer 

pricing and investor evaluations. In addition, better data analysis can better 

define conditions of market liquidity to assist market participants in risk management strategies and investors to better use performance data measurements, specifically indices of price performance and returns. This report highlights significant areas where more robust data collection would have helped 

manage and avert systemic risks exposed in the credit crisis. 

Conclusion 

The municipal industry has evolved outside of a confined regulatory context that 

is outdated and biased, and been consistently challenged by the temptation to regulate in its self-interest. The evolution resulted in detrimental practices and products 

that have proved penal to investors, issuers and the financial institutions. The opportunity to broaden the current regulatory framework has presented itself and in 

acting to take steps to protect the public entities, which require access to capital 

for infrastructure, the new broad regulation of the municipal industry with specific 

attention to both derivatives and cash financial products will provide precedence for 

global regulatory reform of all derivatives. 

The best news is that the MSRB’s current major funding mechanism, fees from 

municipal transactions (more than $20 million in 2008), provides a revenue stream 

to fund expansion and transition of the regulatory purview. In addition, the existing 

organizational infrastructure of the MSRB allows for experienced personnel, technology and data to be powerfully integrated in a revitalized context. 

The municipal regulatory entity must be independent of those it regulates and integrated within a regular Federal entity where the industry can be included and coordinated with regulation of the larger markets. 
150 

Disclosure and Investor Protection 

For a background on municipal disclosure, MMA here quotes from the National 

Federation of Municipal Analysts March 2008 ‘‘White Paper on Federal Securities 

Law Relating to Municipal Securities.’’ The full paper is attached at the end of this 

report. 

The SEC promulgated Rule 15c2-12 (the ‘‘Rule’’ or ‘‘Rule 15c2-12’’) in 1989 

and amended the Rule in 1994 to include continuing disclosure requirements. . . . Direct regulation of issuers would have required repeal of the 

Tower Amendments, so the Rule instead applies to municipal broker-dealers and generally applies to financings where the principal amount offered 

is $1 million or greater. The Rule applies indirectly to issuers, effectively 

denying their access to the market unless the Rule’s requirements are satisfied. The Rule contains primary disclosure requirements and continuing 

disclosure requirements. With respect to continuing disclosure, the Rule 

prohibits the purchase and sale of municipal securities by an underwriter 

in a public offering unless the issuer or an ‘‘obligated person’’ undertakes 

to provide continuing disclosure. Continuing disclosure obligations include 

both periodic reporting of financial and operating information and disclosure of the occurrence of any of a specified list of 11 events, if material. The 

annual information is required to include audited financial statements 

when available and material financial information and operating data of 

the type included in the official statement for the securities. . . . Independent of contractual undertakings made by issuers and conduit borrowers 

and continuing disclosure obligations under Rule 15c2-12, the SEC maintains that issuers of municipal securities and conduit borrowers have continuing disclosure responsibilities under Section 10(b) of the Exchange Act 

and Rule 10b-5. While issuers and conduit borrowers have no affirmative 

duty to disclose information (unless they are engaged in the offering, purchase or sale of securities or unless disclosure is required under a continuing disclosure undertaking), if an issuer or conduit borrower chooses to 

disclose information to the market it is prohibited from disclosing information that is materially untrue or misleading, or that contains a material 

omission, ‘‘in light of the circumstances’’ in which such information is disclosed. There are no other limits on the issuer’s or the conduit borrower’s 

disclosure. 

We also reference DPC Data’s report, ‘‘The Consequences of Poor Disclosure Enforcement in the Municipal Securities Market’’ that provides more information on 

how disclosure is disseminated. Currently disclosure occurs through a regime of several repositories (Nationally Recognized Municipal Securities Information Repositories, or NRMSIRs), but, with recent change in law, a single repository will exist: 

the Municipal Securities Rulemaking Board. In MMA’s opinion, the state of disclosure in the municipal sector should be regarded as poor, and recent changes in the 

law are unlikely to make much difference here. Issuers, as detailed by DPC data’s 

important (and accurate) study on the topic, regularly fall out of compliance with 

stated disclosure requirements, undermining liquidity in selected bonds and hurting 

smaller investors (those without credit analysts trained to track down, or mitigate 

the impact of, absent financial and operating data) who buy bonds, in part, based 

on statements in the prospectus that regular information will be disclosed. 

In MMA’s opinion, disclosure gaps occur because: (1) many issuer representatives 

are not capital markets professionals and lose track of their responsibilities, and (2) 

there is little penalty to be suffered by the industry for not policing compliance. A 

specific failing of SEC Rule 15c2-12 is its leaving the decision on whether an issuer 

is in disclosure compliance to the individual participants trading the issuer’s securities. In our experience, firms have generally ignored this requirement and continued 

to trade likely safe, but disclosure-gapped bonds, albeit at a slight discount. Further, 

we note a pattern of smaller issuers falling out of compliance almost immediately 

after a new offering, remaining out of compliance for several years until, just prior 

to another new primary market loan, the issuer will send its past due financial information to the information repositories. 

Again, MMA believes a solution to municipal disclosure problems is available: 

1. We believe Congress should require that the SEC act as arbiter to determine 

whether each issuer is in compliance with their stated disclosure requirements. 

This would be a very large undertaking, potentially requiring a large staff increase by the SEC. Should the SEC subsume the MSRB, the MSRB’s funds 

could offset at least a portion of the cost. 
151 

2. Bonds found to be not in compliance would be flagged, and registered firms 

would be prohibited in trading in such until either the issue’s original underwriter or any other investor can succeed in getting the issuer to remedy the 

gap. We are reluctant to advise that the SEC be able to compel disclosure directly from the issuers for fear of abridging state autonomy. 

3. The SEC would keep a database to track, for every Cusip and borrower, the 

number and percent of days it has been out of compliance on all of its outstanding bond issues. This statistic would be vitally important for potential 

buyers evaluating new purchases of the borrower’s securities. 

4. Additionally, all firms trading municipal bonds, regardless of their status, 

would need to track how many trades, and the volume of par traded, that firm 

had made with disclosure-flagged municipals Cusips. Again, this could be very 

important data for investors evaluating with which firm to invest their money. 

5. MMA also believes that all tax-relevant calculations and investigations should 

be included in required disclosure topics. These include how tax-exempt bond 

proceeds are being spent, on a weekly basis, the precise formula by which bond 

counsel determines that a bond issue is tax exempt, and the presence and status of any SEC investigations. 

The Undisclosed Risk of Bank Bonds and Swaps 

MMA’s principal concern for the municipal sector in 2009 is that variable-rate related problems will set off a wave of downgrades and even defaults among risky sector credits (such as hospitals and private universities), creating incremental economic loss and threatening more investor aversion to municipal bonds generally. 

But the risks in variable-rate demand obligations are not exclusive to hospitals; 

many state and local governments also issued these securities and face very similar 

credit challenges. 

VRDOs are long maturity bonds where the interest rate is periodically (weekly, 

daily, etc.) reset by a remarketing agent—usually a dealer bank—who also attempts 

to make proprietary markets in these securities among a universe of the firm’s clients with a strong focus on tax-exempt money market funds. VRDOs also entail 

some form of liquidity support (structured via a letter of credit or standby purchase 

agreement) from a highly rated bank. In other words, a bank is contractually obligated to become the immediate buyer of last resort for a VRDO, giving money market funds confidence in the liquidity of a VRDO investment. MMA estimates that 

there are about $500Bn of outstanding VRDOs at present; this number has likely 

increased from $400Bn since the start of 2008 reflecting numerous post-collapse 

ARS restructurings into VRDOs. 

Yet today’s financial markets entail substantially more investor caution among 

banks and between credits generally, and large numbers of VRDOs have been rejected by the money funds because of their reliance on a damaged or downgraded 

liquidity provider (most notably DEPFA and Dexia) or connection to a downgraded 

bond insurer. In the absence of other investors or remarketing agents’ inability to 

bring yet more bonds onto their own balance sheets, many of these rejected bonds 

have triggered their liquidity features, requiring the liquidity providers to buy these 

securities directly. Provider-purchased VRDOs are referred to as ‘‘bank bonds,’’ 

which the liquidity providers hold as available for sale for a period of time (for example, 90 days), but then convert to accelerated maturity term loans between the 

liquidity provider and the issuer. It is unclear whether any municipal bank bonds 

have actually yet converted to term loans, but their acceleration of principal and 

penalty interest rate would reasonably require either an immediate restructuring or 

a default forbearance agreement between provider and issuer. Because there is little 

hope for market interest in Dexia or DEPFA to improve, at some point, issuer defaults may become public. MMA estimates, based on our polling of industry sources, 

that there have been as many as $50Bn of rejected floaters, with perhaps $50Bn 

more being kept away from liquidity providers through special—and thus potentially 

temporary—intervention by securities dealers. MMA believes that the amount of 

bank bonds has fallen in 2009, as issuers are actively restructuring their bank bond 

obligations, although we underscore that we are unaware of any information being 

collected by any regulator or data provider on this topic. 

Interestingly, the rejection of many VRDOs by the money funds has worsened 

problems elsewhere in the municipal floating-rate markets. First, it has required liquidity providers to become more cautious in writing new policies, increasing the 

scarcity and cost of same for municipal issuers. Second, by removing large swathes 

of floaters from money fund ‘‘approved’’ lists, and noting: (1) the near complete absence of TOB-related lending by the money funds (see ‘‘Background’’ section above), 

and (2) large, fear driven investor inflows into the money funds, has created a se-
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vere supply/demand imbalance. Approved and available securities are scarce and— 

because the funds’ alternative is not investing their funds at all—are being bid up 

to extremely low yields (weekly interest rates have been close to, or well below 1 

percent since November). Low benchmark floating rates, along with very strong demand for long-maturity LIBOR swap rates, an unwinding of arbitrageurs’ interest 

rate hedges, and a dearth of new municipal issuer derivative activity, has pushed 

the related long-maturity municipal swap rates to very low levels. And this movement in swap rates has greatly increased issuers’ cost of terminating any outstanding swap, complicating the restructuring of any distressed VRDO position. 

Further, higher issuer swap termination costs have produced substantial cash 

drains away from issuers via requirements that the issuers collateralize their potential termination liability to their counterparty. (Many issuers had purchased bond 

insurance AAAs to ward off credit- or rate-driven collateralization requirements. But 

with the insurers’ losing their ratings, many issuers are no longer shielded, sometimes removing cash to the detriment of normal operations.) As not-for-profit hospitals have been particularly large users of this debt structure, and as these same 

hospitals also face lower private pay revenues and strained governmental reimbursements, defaults are likely in the near term. Because swap positions are only 

dimly disclosed, even sophisticated municipal investors remain largely without information on their own portfolios’ related risks. 

Once again, these municipal issuer exposures to systemic risks were accreted with 

little public disclosure or regulatory insight. Further, MMA is unaware of any municipal regulator or information provider systematically collecting information on 

the size and scope of this problem. This not only inhibits better projection of potential losses, but also prevents a more robust response from national regulators (e.g., 

Treasury, the Federal Reserve, the SEC) who are struggling to grasp the depth of 

the problem and coordinate their response with those in other asset classes. Solutions are well within Federal abilities. MMA recommends that Treasury extend subsidized loans to municipal issuers to terminate difficult swap positions, with the cost 

of those loans recouped by Treasury via a surcharge on all future issuer swap activity. This would allow issuers to restructure their obligations into fixed rate bonds, 

relieving liquidity provider balance sheets of troubled exposures, and potentially encouraging future policy writing. 

Auction-Rate Securities and Unchecked Systemic Risks 

Auction-Rate Securities (ARS) are long maturity bonds where the interest rate is 

periodically reset by auction among potential investors, or failing that, set manually 

by a bank pursuant to an index or (typically very high) fixed rate. Because they are 

valued at par, ARS were typically purchased by individual investors as a higheryielding alternative to cash deposits. However, higher yields reflected the fact that 

an ARS holder cannot sell their bond without an identified buyer: a sharp distinction from other ‘‘cash like’’ instruments that required dealer banks to periodically 

step in as a buyer to prevent auctions from failing. In part because of this reliance 

on bank intervention, ARS programs were (and still are) set up as proprietary trading exchanges by individual dealers, inhibiting the easy flow of capital and information from program to program. 

The implications of the ARS structure, in the context of the municipal industry’s 

systemic exposure to the bond insurers and the financial counterparties were little 

understood by issuers, investors, or the dealer banks themselves prior to 2007. It 

was the collapse of the bond insurers in 2007 that undermined investor confidence 

in ARS issuers and precipitated vast selling. (Remember that individual investors 

had long been sold on the AAA virtues of bond insurance; this myth was not so easy 

to dispel when bond insurer downgrades began). Banks were initially able to use 

their own cash to buy back securities, but in January 2008, bank risk tolerances 

prevented further purchases, and ARS auctions began to fail. Thus, current holders 

were left without a means to get out of their positions, and issuers were forced to 

pay sometimes highly punitive fixed interest rates. Since that time, MMA estimates 

that about two thirds of ARS issuers have restructured or refinanced their securities, although many remain unable to do so as: (1) refinances with liquidity-supported floating-rate debt require the purchase of a liquidity policy from a highly 

rated bank—these policies have become both scarce and expensive as U.S. banks 

have reduced lending; and (2) refinances with fixed-rate debt are prevented not only 

by the high fixed rates many lower-rated issuers must now pay, but also the sometimes staggering cost of terminating the interest rate swap most municipal issuers 

have connected to their bond sales (please see bank bonds section, above). 

Thus, many investors still remain stuck with highly illiquid securities that are 

paying well-below-market, index-linked interest rates. At issue is an unwillingness 

to allow ARS to trade at a discount to entice potential buyers, because of the in-
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crease in potential liability and because sub-par pricing of these holdings could result in additional waves of mark-to-market losses for the already stressed banks. Although private trading venues have emerged to provide emergency assistance to distressed clients needing to liquidate their holdings at any price, we are unaware of 

any broker dealer making sub-par markets in any ARS. On the other hand, several 

of the large banks have, on the intervention of state securities regulators, settled 

with their individual and small institutional investors, in effect buying ARS securities back at par. Indeed, the largest current holders of ARS are likely the dealer 

firms themselves that are still carrying their swollen inventories from 2008 and now 

the bonds purchased via settlement. 

ARS shows another breakdown in the municipal regulatory framework. While 

there are initiatives to improve ARS price discovery, no market participant (including investors, dealer banks, nor the regulators themselves) knows precisely how 

many ARS are outstanding (MMA’s estimate was about $200Bn municipal ARS at 

the market’s peak), how many bonds were being placed through each dealer program, how many ARS issuers were reliant on bond insurance for their marketing 

to investors, the extent and means by which these issuers were leveraging 

counterparty credit through interest rate derivatives, and how much dealer support 

was being directly extended to the market. The implications for systemic risk management, as now being discovered in the credit crisis, are clear in these questions, 

which can (and should) be extended to the still healthy, but periodically threatened, 

municipal VRDO market. 

Municipal Bond Ratings and Bond Insurance 

Most municipal bonds are rated on a different, more conservative rating scale 

than corporate bonds. Moody’s and Standard & Poor’s have shown that triple-A U.S. 

corporate bonds have up to 10 times the historical default rate of single-A municipals. In MMA’s opinion, neither municipal issuers, nor the individual investors who 

own the large majority of outstanding paper or fund shares, understands this point. 

But instead of requiring more accurate ratings, the municipal industry (i.e., issuers, 

investors, and underwriters) has instead chosen to make bonds appear safer and 

more similar through bond insurance (the insurers are rated along the more generous corporate rating scale; much of the bond insurance model distills to simple 

arbitrage between the two rating scales). At its peak, the municipal bond insurance 

industry entailed just nine companies whose ratings were applied to more than 50 

percent of annual municipal bond sales. And this invited massive systemic exposure 

into the municipal industry as the bond insurers carried in the risk of subprime 

mortgage-backed securities, the insurers’ and the financial sectors’ leverage of ratings on securitized debt, and failed rating agency models. 

Attached, please find our January 2008 report, ‘‘MMA on Corporate Equivalent 

Ratings,’’ and our April 2008 report, ‘‘Second Research Note on Moody’s,’’ for more 

detail on the problem with how municipal bonds have been rated. In the last year, 

both Moody’s and Fitch ratings strongly considered reforming their muni rating 

processes, but both have tabled these initiatives because of the recession. Standard 

and Poor’s continues to deny the existence of separate rating scales for municipals 

and corporate bonds, but that agency has embarked on a plan of sweeping upgrades 

to selected municipal sectors. Finally, the U.S. House of Representatives considered 

the ‘‘Municipal Bond Ratings Fairness Act of 2008,’’ which MMA believes would, for 

little cost to taxpayers, successfully remediate much of the rating problem in our 

sector. We strongly recommend that Congress adopt this legislation in its current 

form. MMA has been a leader on the topic of ratings and the municipal sector’s use 

of bond insurance; we welcome any opportunities to continue to educate Congress 

and its agents on these topics. 

Pricing and Evaluation Issues 

The events of the past 18 months have amplified the risks and challenges associated with illiquidity and limited price discovery for municipal bond investors and 

issuers. 

The municipal bond industry has been challenged with a troublesome irony. While 

municipal bonds have favorable low historical default risks, the securities can be illiquid. How can a safe investment not have liquidity? Inconsistency of primary market pricing, the eclectic composition and multitude of issuing entities, the penal and 

overly granular ratings scale, reduced number of liquidity providers, the diminished 

number of AAA bond insurers and the inability to manage interest rate and credit 

risk have contributed to the challenges for the markets transactions to provide evaluation services with sufficient price discovery. The result is that evaluations that 

represent the price that investors receive on their investment firm statements or the 

prices that comprise the net asset value of a mutual fund share may bear little re-
154 

semblance to an execution price should an investor choose to buy or sell. In addition, 

the periodic illiquid market conditions and limited price can result in sharp volatility that can be misinterpreted as credit or default risk, either of which may not 

be valid. In this manner the data can misinform an investor and potentially prompt 

emotional and inappropriate investment decisions. These same characteristics can 

also increase the difficulty for municipal issuers to assess market conditions and accurately predict market demand to give context for the pricing of their primary market deal. 

An aggressive, investigative and knowledgeable regulator with access to all transactions and who conducted each transaction, can assist consumers—both the investor and borrower—with providing a context to ensure that the data is relied upon 

by consumers inspires confidence and provides an objective context in which investors and issuers can make decisions from the prices of their securities. 

Schedule of Additional Attachments 

MMA has attached the following documents, under separate Acrobat file, in support of the arguments made herein. 

• NFMA White Paper ‘‘Federal Securities Law Relating to Municipal Securities’’ 

March 2008 

• DPC Data ‘‘The Consequences of Poor Disclosure Enforcement in The Municipal 

Securities Market’’ January 2009 

• Municipal Market Advisors ‘‘Corporate Ratings for Munis’’ January 2008 

• Municipal Market Advisors ‘‘Second Research Note on Moody’s’’ April 2008 
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PREPARED STATEMENT OF LYNN E. TURNER 

FORMER CHIEF ACCOUNTANT, 

SECURITIES AND EXCHANGE COMMISSION

MARCH 10, 2009 

Thank you Chairman Dodd and Ranking Member Shelby for holding this hearing 

on an issue important to not only investors in America’s capital markets, but to all 

who are being impacted by the current economic devastation. 

Before I start with my personal perspective on the issues surrounding the current 

economic crisis and securities regulation, it might be worthwhile to provide some 

background on my experience. I serve as a trustee of a mutual fund and a public 

pension fund. I have served as an executive of an international semiconductor manufacturer as well as on the board of directors of both Fortune 500 and small cap 

public companies. In the past, I served as chief accountant of the U.S. Securities 

and Exchange Commission (SEC) and as a partner in one of the major international 

auditing firms, where I was involved with audits and restructurings of troubled or 

failed institutions. I also was the managing director of research at a financial and 

proxy advisory firm. In addition, I have also been a professor of accounting at a 

major U.S. public university and an investor representative on the Public Companies Accounting Oversight Board (PCAOB) Standards Advisory Group and the Financial Accounting Standards Board’s (FASB) Investor Technical Advisory Committee (ITAC). 

The Crisis—Bad Loans, Bad Gatekeepers, and Bad Regulation 

The economic crisis of 2007–2009 has three root causes; the making of bad loans 

with other peoples money, gatekeepers who sold out, and a lack of regulation. In 

order to prevent a repeat of this debacle it is of paramount importance that policy 

makers understand what will cure the ‘‘disease’’ before they remedy the cause. To 

that end, I would urge the committee to take the same approach it did some seven 

decades ago when the Senate Banking Committee, with experienced investigators 

using its subpoena powers, investigated the banking and security markets, stock exchanges, and conduct of their participants. A similar approach in the midst of the 

current crisis would give Americans and investors hope and confidence that their 

interests will be served, and adequate protections restored. Unfortunately, if the 

public perceives the remedy is off target, as it has with other recent legislation, I 

fear the markets will continue their downward spiral resulting in a lengthening of 

the recession, or potentially worse outcome. 

From my perspective, those most responsible for the current crisis are the banks, 

mortgage bankers, and finance companies who took money from depositors and investors and loaned it out to people who simply could not, or did not repay it. In 

some instances predatory practices occurred. In other instances, people borrowed 

more than they should have as Americans in general ‘‘leveraged’’ their personal and 

corporate balance sheets to the max. Speculators also took out loans expecting that 

real estate values would continue to rise, allowing them to profit from flipping their 

investments. But who can dispute that when ‘‘liar,’’ ‘‘no doc,’’ and ‘‘Ninja loans’’ are 

being made while banking regulators are watching, there is something seriously 

wrong. 

In addition to the financiers, a second problem was the gatekeepers—the credit 

rating agencies and underwriters—who are suppose to protect investors. They did 

anything but that. Instead they became the facilitators of this fraud on the American public, rather than holding up a stop sign and putting the brakes on what was 

occurring. They became blinded by the dollars they were billing rather than providing insight to the public into the perfect storm that was forming. Recent testimony before the House of Representatives that the rating agencies knew their models did not work, but did not fix them was stunning. But perhaps not as stunning 

as the report of the SEC in which employees of an agency stated they would rate 

a product even if it had been created by a cow. 

And while lenders were making bad loans in exchange for up-front fees, and gatekeepers were falling down on the job, Federal Government agencies were failing to 

supervise or regulate those under their oversight, as well as failing to enforce laws. 

It is a huge public concern that a systemic failure of financial and securities market 

regulation in this country occurred. Some of this was due to the lack of regulation 

of new products and institutions, such as credit default swaps and hedge funds, but 

more importantly, the fundamental problem was the lack of Federal Government 

regulators doing their jobs, or lacking the resources to do so. 
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For example, for 13 years, as abuses of subprime lending occurred, the Federal 

Reserve refused to issue regulations as mandated by the Homeownership Equity 

Protection Act of 1994 (HOPEA). That legislation specifically stated: 

PROHIBITIONS—The Board, by regulation or order, shall prohibit acts or 

practices in connection with— ‘‘(A) mortgage loans that the Board finds to 

be unfair, deceptive, or designed to evade the provisions of this section; and 

(B) refinancing of mortgage loans that the Board finds to be associated with 

abusive lending practices, or that are otherwise not in the interest of the 

borrower.’’. 

Not less than once during the 3-year period beginning on the date of enactment of this Act , and regularly thereafter, the Board of Governors of the 

Federal Reserve System, in consultation with the Consumer Advisory Council of the Board, shall conduct a public hearing to examine the home equity 

loan market and the adequacy of existing regulatory and legislative provisions and the provisions of this subtitle in protecting the interests of consumers, and low-income consumers in particular . . . 

Yet the Federal Reserve Board (Federal Reserve or Fed), which had examiners in 

the very banks who were making mortgage loans, did nothing. Had the Federal Reserve acted, much of the subprime disaster might have been averted. Instead, ignoring the clarion calls of one of its own Governors for action, the late Edward 

Gramlich, it was not until 2007 that the Federal Reserve acted. But by then, much 

of the damage to the American economy and capital markets had been done. 

Indeed, even the Comptroller of the Currency spoke in 2006 of 3 years of lowering 

of lending standards. In a press release in 2006, the Comptroller stated: 

‘‘What the Underwriting Survey says this year should give us pause,’’ Mr. 

Dugan said. ‘‘Loan standards have now eased for three consecutive years.’’ 

The Comptroller reported ‘‘slippage’’ in commercial lending involving leverage lending and large corporate loans as well as in retail lending with significant easing in residential mortgage lending standards including home 

equity loans. [Emphasis supplied] 

Unfortunately, armed with this information and legislative authority to fix the 

problem, the Comptroller of the Currency (OCC) failed to act in earlier years. Rather than reining in these abusive practices, the OCC permitted them to continue, 

with the most toxic of the subprime loans being originated in 2006 or 2007. And 

today, we have Inspector General reports that have cited the lack of action by the 

OCC and Office of Thrift Supervision, leaving taxpayers and investors exposed to 

losses totaling trillions of dollars. 

What is equally troubling about this lack of action by the banking regulators, is 

that it comes after similar problems occurred with the crisis in the savings and loan 

and banking industries in the 1980s and early 1990s. I was at the SEC at that time 

and watched as the Federal Reserve who had oversight over an undercapitalized 

CitiBank, worked to keep it afloat. It seems that we are seeing a repeat performance of this situation and rather than having learned from history, we are again 

repeating it. After having two swings at the bat, I wonder why some want to make 

the same regulators the risk regulator for the entire financial system in the United 

States. These are regulators who all too often have been captured by the regulated. 

Once again, as with Enron, a lack of transparency has also been a contributing 

factor to the current crisis. Investors have time and time again—from Bear Stearns 

to Lehman to Wachovia to Citigroup and Bank of America—questioned the validity 

of the financial numbers they are being provided. The prices of their stocks have 

reflected this lack of credibility driven by transactions hidden off the balance sheets 

and values of investments and loans that fail to reflect their real values. 

Unfortunately, millions of bad loans were made that are not going to be repaid. 

While financial institutions argue they will hold the loans to maturity and be repaid, that just isn’t true for loans subject to foreclosures or short sales. And for 

many mortgages, they prepay and once again are not held to maturity. At the same 

time, collateral values of the underlying assets securing the loans have taken a tremendous tumble in values. Almost 5 million Americans have lost their jobs since 

this recession began impacting their ability to make their mortgage payments. 

There is a years worth of inventory of unsold homes on the market even further 

depressing home prices. Asset backed securities are being sold in actual transactions 

at pennies on the dollar. Yet the financial institutions continue to act like an ostrich 

with their head in the sand and ignore these facts when valuing their assets. At 

the same time however, the markets are looking through these numbers and revaluing the stocks in what is an inefficient approach, driving stocks of some of the larg-
222 

est financial institutions in this country to a price that is lower than what you can 

buy a Happy Meal for at McDonalds. 

In 1991 the General Accounting Office (GAO) published a report titled ‘‘Failed 

Banks—Accounting and Auditing Reforms Urgently Needed.’’ In their report, the 

GAO noted how during the savings and loan crisis, the failure of banks and savings 

and loans to promptly reflect their loans and assets at their market values drove 

up the cost to the taxpayer. I hope Congress will not allow this mistake to be repeated by allowing banks to avoid marking their assets to market. 

Managing the assets held by a financial institution and the positions taken has 

also been lacking. One large institution that was failing and required a bailout 

through a buyer did not even have a chief risk officer in place as the risks that 

caused their demise were entered into. This could have been avoided in if the recommendations of the 2001 Shipley Working Group on Public Disclosure had been 

adopted by the banking and securities regulators that had convened the group. Instead, consistent with a deregulatory approach, the type of risk disclosures the 

group called remained nonexistent, hiding the buildup of risks in the financial system. 

There has also been a lack of regulation of new products and institutions. Credit 

rating agencies were not subject to regulation by the SEC until after many of the 

subprime loans had been made. Credit default swaps and derivatives were specifically exempted by Congress from regulation, despite a plea for regulation from the 

CFTC chairman, creating grave systemic risks for the financial system. These markets grew to over $60 trillion, a multiple of many times the actual debt subject to 

these swaps. In essence, a betting system had been established whereby people were 

wagering on whether others would pay their debt. But while we regulate betting in 

Las Vegas, congress chose to specifically not regulate such weapons of mass destruction in the capital markets. This has directly led to the more than $160 billion bailout of the bets AIG placed, and those to whom it is indebted on those on those bets. 

Likewise, there has been a rise in a shadow banking system that includes hedge 

funds and private equity firms. These funds have under management money from 

many public sources, such as public pension funds and their members and the endowments of colleges and universities. Yet they remain largely opaque and these unregulated entities have been allowed to co-exist alongside the regulated firms as a 

push was made for less regulation. That push was advanced by an argument the 

markets can regulate themselves, a perspective that has been proven to totally lack 

any credibility during this decade of one scandal after another. Others said that 

without regulation, these unregulated entities could innovate and create great 

wealth. Unfortunately, their innovation has not always created wealth and in other 

instances has been quite destructive. 

The subprime crisis, and our economic free fall, is the showcase for what can happen without adequate regulation and enforcement. Those who made the loans including mortgage bankers, the credit rating agencies who put their stamp of approval on the Ninja, no doc and liar loans, and the investment bankers who packaged them up and sold them to an unsuspecting public were all unregulated or regulated only in a token fashion. 

Unfortunately, the deregulation of the U.S. capital markets that many not so long 

ago called for, has not resulted in increased competitiveness of the markets. Rather 

it has left the preeminence and credibility of our capital markets shattered. Instead 

of making the allocation of capital more efficient, it has resulted in a lack of transparency and mispricing and misallocation of capital. Investors have watched as over 

ten trillion in wealth has disappeared. And instead of fueling a growth in our economy, we have seen it fall into a decline the likes that haven’t been seen since the 

great depression. Indeed, some have now called our situation the ‘‘Not So Great Depression’’ and one commentator, Stephen Roach of Morgan Stanley has warned of 

a Japanese style economy that continues to this day to sputter along. 

Reforms—The Long Road Back 

On a bipartisan basis, we have dug the hole we find ourselves in over an extended 

period of time. During much of that time we have enjoyed economic prosperity that 

in recent years contributed to the ‘‘suspended disbelief’’ that the good times would 

never end. All too often people spoke of the ‘‘New Economy’’ and those who doubted 

it or warned of dangers were treated as outcasts. But as with many a bubble in the 

past, this one too has burst. 

The capital markets have always been the crown jewel of our economy—the engine that powered it. And it can once again achieve that status, firing on all cylinders, but only if care is taken in structuring reforms that protect the investing 

public. 
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Basic Principles 

In creating regulator reform, I believe there are some critical fundamental principles that should be established. They include: 

1. Independence 

2. Transparency 

3. Accountability 

4. Enforcement of the law 

5. Adequate Resources 

Independence 

Those responsible for oversight, including regulators and gatekeepers, must be 

independent and free of conflicts and bias when doing their jobs. And it is not just 

enough that they are independent on paper, they must be perceived by investors to 

be free of conflicts avoiding arrangements that cause investors to question their 

independence. They need to be free of political pressures that unduly influence their 

ability to carry out their mandates to protect the American consumer and investor. 

They must avoid capture by the regulated. And their ability to get resources should 

not be contingent on whether they reach a favorable decision for one special interest 

group or political affiliation. 

This is especially true of regulators such as the SEC and CFTC. These agencies 

must avoid becoming political footballs thrown between opposing benches. Unfortunately, that has not always been the case as we saw recently at the SEC or with 

the CFTC when it asked for regulation of credit derivatives. 

Similarly, the credit rating agencies have suffered from some of the same lack of 

independence the auditors did before Enron, WorldCom, and the enactment of the 

Sarbanes-Oxley Act of 2002 (SOX). They became captured by the desire to increase 

revenues at just about any cost, while ignoring their gatekeeper role. 

Independence also means there is a lack of conflicts that can impact one’s independent thinking. For example, when a bank originates a subprime loan it may will 

ask its investment banking arm to securitize it. But if it is a no doc, liar loan or 

Ninja loan, will the investment banker perform sufficient due diligence and ensure 

full and fair disclosure is made to the investors clearly delineating in plain English 

what they are being sold? I doubt that has really occurred. 

Unfortunately, when the Gramm-Leach-Bliley Act was passed, allowing the creation of giant financial supermarkets, it failed to legislate and adequately address 

such conflicts. In fact, it did not address them at all leaving us with huge conflicts 

that have now given rise to investments that are not suitable for the vast majority 

of investors. Given this Act gave an implicit blessing to the creation of institutions 

that are ‘‘Too Big To Fail’’ and knowing that after the failure of Long Term Capital 

management the creation of such institutions brings with it the backing of taxpayers money, this serious deficiency in the laws governing regulation of conflicts 

of interests in these institutions needs to be addressed in a robust fashion. 

Transparency 

Transparency is the life blood of the markets. Investors allocate their capital to 

those markets where they get higher returns. Investors need the best possible financial information on which to base their decisions as to which capital markets they 

will invest in, and which companies, in order to generate the maximum possible returns. Maximizing those returns is critical to investors, and institutions who manage their investments, as it determines how much they will have for retirement, or 

spending. 

Investors will allocate their capital to those markets where returns are maximized. While economic growth in a particular country has a significant impact on 

returns for a capital market, the quality of the information provided to those who 

allocate capital also significant impacts it. In general, the better the information, 

the better the decisions made, and the more efficiently capital is allocated and returns maximized. 

The U.S. capital markets have maintained their lead in transparency, albeit our 

pride in that respect has been tarnished by off balance sheeting financings, a lack 

of disclosures regarding the quality of securities being sold, and credit ratings that 

were at best poorly done, if not outright misleading. Nonetheless, even in today’s 

markets, the U.S. markets have continued to outperform foreign markets. 

Accountability 

Accountability clearly places the responsibility for decisions made and actions 

taken. People act differently when they know they will be held accountable. When 

people know there is a state trooper ahead on the highway, they typically drive ac-
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cordingly. When they know there is no trooper, a portion of the population will hit 

the accelerator and speed ahead. 

There needs to be greater accountability built into the system. The executives and 

boards of directors of the financial institutions that have made the bad loans bringing our economy to its knees, causing Americans to lose their jobs, students to have 

to forgo their education, all at a great cost to the taxpayer should be held accountable. The American public will demand nothing less. 

The banking, insurance, commodities and securities regulators all need to have 

greater accountability. We need to know that we have a real cop on the beat, not 

just one in uniform standing on a corner. 

Likewise, gatekeepers must be held accountable for the product they provide the 

capital markets. Their product is critical to ensuring the credibility of financial information needed for capital allocation. 

Enforcement 

We are a Nation of laws. The laws governing the capital markets and banking 

in this country have been developed to provide protections for investors and consumers alike. They provide confidence that the money they have worked hard for, 

when invested, is safe from abusive, misleading and fraudulent practices. Without 

such laws, people would be much more reluctant to provide capital to banks and 

public companies that can be put to work creating new plants and products and 

jobs. 

But laws aren’t worth the paper they are written on if they are not properly enforced. An unleveled playing field in the markets brought on by a lack of enforcement of laws providing consumer and investor protections can have the devastating 

effect we are now seeing. For example, the Financial Accounting Standards Board 

Chairman has written members of this committee citing how some institutions were 

not properly following the standards hiding transactions off balance sheet. Yet to 

date, enforcement agencies have not brought any cases in that regard. 

And laws are not just enforced by the law enforcement agencies, but also through 

private rights of actions of investors and consumers. This is critically important as 

law enforcement agencies have lacked the adequate resources to get the job done 

alone. 

Unfortunately, in recent years we have seen an erosion of investor and consumer 

rights to enforce the laws. Court cases setting up huge hurdles to these attempts 

to enforce the laws have made it much more costly taking significant time and resources to get justice. For example, one such court decision has now made it in essence legal for someone to knowingly aid another party in the commission of a fraud 

on investors, yet be protected by the courts from legal liability. It is akin to saying 

that if one drives a getaway car for a bank robber, they can go to jail. But if one 

wears a white collar and provides assistance to such a fraud in the securities market, they get a pass. Something is just simply wrong when that is allowed to occur 

in our Nation. Congress needs to remedy this promptly with legislation Senator 

Shelby introduced 7 years ago in 2002. 

Likewise we have seen passage of laws such as the Commodities Modernization 

Act of 2000 which also put handcuffs on our enforcement and regulatory agencies. 

This Act passed in the waning moments of that Congress at the requests of special 

interests. Supported by government officials, the Act specifically prevented the SEC 

and CFTC from regulating the derivatives market now totaling hundreds of trillions 

of dollars. These handcuffs need to be promptly removed. The securities and commodities laws need to be clarified to give the CFTC the authority to regulate commodities and any derivative thereof such as carbon trading, and the SEC the authority to regulate securities and any derivative thereof such as credit derivatives. 

Adequate Resources 

No one can do their job if they are not provided the proper tools, sufficient staffing 

and other resources necessary for the job. This includes being provided the necessary authority through legislation to do the job. It means Congress has to provide 

a budget to these agencies to hire sufficient number of staff. But it is not just the 

numbers that count, the agencies must also be given enough money to hire staff 

with sufficient experience. For example, while I was at the SEC, the budget you provided to the agency did not give the Office of Compliance Inspections and Examination a sufficient number of staff. And it certainly did not provide the office with 

enough money to hire senior experienced examiners who had the type of depth and 

breadth of expertise in the industry that was necessary to do the job right. Whose 

fault is it then when that agency fails to detects frauds through their examinations? 

I would say a good part of the blame lies at the feet of Congress. 
225 

I would urge you to take a look at how these agencies that are so critical to the 

proper functioning of our markets are funded. In the case of the SEC, it collects sufficient fees to pay for an adequate budget. Yet each year it must go hat in hand 

to ask for a portion of those fees in an amount that has not met its needs. Instead, 

the SEC should be removed from the annual budget process and established as an 

independently funded agency; free to keep the fees it collects to fund its budgets. 

Necessary Reforms 

Once again, before legislating reforms, I would urge this committee to undertake 

‘‘Pecora’’ hearings to ensure it gets the job done right. Some of the reforms that I 

believe are necessary, and which could be examined in such hearings include the 

following; 

Regulatory Structure: Arbitrage among banking regulators should be eliminated, 

and accountability for examination and regulation of banks centralized in one agency. To accomplish that, Congress should once again consider the legislation offered 

in 1994 by the former Chairman of this Committee, Donald Reigle. That legislation 

would combine the examination function into one new agency, while having the 

FDIC remain in its role as an insurer and the Federal Reserve as the central banker. Careful consideration needs to be given to the conflicts that arise when the central banker both sets monetary policy, such as when it created low interest rates 

earlier this decade, and then regulates the very banks such as Citigroup and Country Wide that exploit that policy, and at the same time fails to put in place safeguards as the Fed had been asked to do by Congress in 1994. And the mission of 

the new agency, as well as the missions of the FDIC and Fed with respect to consumer and investor protection needs to be made much more explicit. All too often 

these regulators have been captured by industry, much to the detriment of consumers and investors and in the name of safety and soundness. Yet we have learned 

that what is good for consumers and investors alike, is also good for safety and 

soundness, but not necessarily the reverse. 

I believe the roles of the CFTC and SEC should be clarified. I do not support the 

merger of the two agencies as I don’t believe the synergies some believe exist will 

be achieved. I also believe commodities and securities are fundamentally two different markets, with significantly differing risks, and the regulator needs significantly differing skill sets to regulate them. Accordingly, as I have previously mentioned, I would clarify the roles of these two agencies by giving all commodities and 

derivatives thereof to the CFTC to regulate, and all securities and derivatives thereof to the SEC. 

Some have argued for the creation of new agencies. To date; I have yet to see the 

need for that. For example, some have argued that a separate investor and consumer protection agency should be created. However, when it comes to the securities 

markets, I believe the SEC should continue in that role, and given the resources 

to do so. 

Over the years, the SEC has shown it can be a strong investor protection agency. 

It has only been in recent years, when quite frankly people who did not believe in 

regulation were appointed to the Commission, that it fell down on the job. By appointing investor minded individuals to the Commission, who have a demonstrated 

track record of serving and protecting the public, this problem can be fixed. Likewise however, if a separate agency is created, but the wrong people put in place to 

run it, we will see a repeat performance of what has occurred at the SEC. 

Gaps in Regulation: There are certain gaps in regulation that are in need of fixing. Credit derivatives should become subject to regulation by the SEC as former 

SEC Chairman Cox urged this committee to do some time ago. While the establishment of a clearing house is a positive development, in and of itself it is insufficient. 

I understand the securities laws generally exclude over-the-counter swaps from 

SEC regulation. This improperly limits the SEC’s ability to provide for appropriate 

investor protection and market quality. The OTC derivatives market is enormous, 

and proper regulation is in the public interest. The SEC would be in a better position to provide that regulation if the following changes were made: 

• Repeal the exclusion of security-based swap agreements from the definition of 

‘‘security’’ under the Securities Act of 1933 and Securities Exchange Act of 1934. 

• Include within the definition of ‘‘security’’ financial products that are economic 

derivatives for securities. It is important to consolidate the regulatory authority 

at the SEC because of its investor protection and capital markets mandate. 

While the SEC has a mandate to protect investors and consumers, other regulators may lose sight of that mission. Based on my business and agricultural 

background, I have found derivatives in agriculture and other physical commod-
226 

ities have a different purpose than financial derivatives as they permit risk 

management and secure supplies for users and producers of goods. 

• Require all transactions in securities to be executed on a registered securities 

exchange and cleared through a registered clearing agency. 

There needs to be much greater transparency for this market. The recent reluctance of the FED to disclose the counter parties receiving the bailout in connection 

with AIG is alarming but not surprising. Even the current Fed Chairman has stated 

this is an agency that has been all too opaque in the past. 

There needs to be greater disclosure to the public of the trading, pricing and positions of these arrangements. There also needs to be disclosure identifying the 

counterparties when the impact of the contracts could have a material effect on 

their operations, performance or liquidity. Given the deficiencies that have existed 

in some contracts, there also needs to be more transparency provided around the 

nature, terms, and amounts of such contracts when they are material. 

There is also a legitimate question as to whether one party should be able to bet 

on whether another party will pay their debt, when the bettor has no underlying 

direct interest in the debt. Certainly as we have seen at AIG and elsewhere, these 

contracts can have devastating effect. Quite frankly, they do not serve a useful purpose for investors as a whole in the capital markets. As such, I would like to see 

them prohibited. 

There is also a gap in regulation of the municipal securities market as a result 

of what is known as the Tower Amendment. Recent SEC enforcement actions such 

as with the City of San Diego, the problems in the auction rate securities, and the 

lurking problems with pension obligation bonds, all cry out for greater regulation 

and transparency in these markets. These token regulated municipal market now 

amount to trillions of dollars and poses very real and significant risks. Accordingly, 

as former Chairman Cox recommended, I believe Section 15B(d)—Issuance of Municipal Securities—of the Securities Act of 1934 should be deleted. 

The SEC should be given authority to regulate hedge and private equity funds 

that directly or indirectly take public capital including from retail investors. They 

should be subject to the same type of regulation as their counter parts in the mutual 

fund market. This regulation should give the SEC the (i) authority to require the 

funds to register with the SEC, (ii) give the SEC the authority to inspect these 

firms, (iii) require greater transparency through public quarterly filings of their positions and their financial statements and (iv) give the SEC appropriate enforcement 

capabilities when their conduct causes damage to investors or the financial markets 

and system. 

As testimony before this committee in the past has demonstrated, the SEC has 

insufficient authority over the credit ratings agencies despite the roles those firms 

played in Enron and now the subprime crisis. This deficiency needs to be remedied 

by giving the SEC the authority to inspect credit ratings, just as Congress gave the 

PCAOB the ability to inspect independent audits. In addition, the SEC should be 

given the authority to fine the agencies or their employees who fail to adequately 

protect investors. Greater transparency should be provided to credit ratings themselves. And disclosure should be required, similar to that for independent auditors 

of potential conflicts of interests. 

The SEC, CFTC and Banking Regulators should also be given powers to regulate 

new financial products issued by those whom they regulate. This should be accomplished through disclosure. The agencies should have to make a determination that 

adequate disclosures have been made to consumers and investors regarding the 

risks, terms conditions of new products before they can be marketed. If a new product is determined by an agency to present great risk to the financial system or investors, the regulating agency should be empowered to prevent it from coming to 

market, just as is done with new drugs. 

In addition, there needs to be greater regulation of mortgage brokers. Some States 

have already made progress in this regards. However, the Federal banking regulators should be given power to provide consumers necessary protections, if they find 

that state regulators have failed to do so. 

Greater Accountability Through Improved Governance and Investor Rights: Legislation equivalent to an investor’s Bill of Rights should be adopted. Investors own 

the company and should have some basic fundamental rights with respect to their 

ownership and investments. It is well known that investors in the U.S. lack some 

of the fundamental rights they have in foreign countries such as the United Kingdom, the Netherlands and Australia. Yet while some argue for regulation and regulators similar to those in foreign countries, these very same people often oppose importing investor rights from those same countries into our system of governance. 
227 

The excesses of executive compensation have been well documented and need no 

further discussion. Some have argued investors have an ability to directly address 

this by voting for or against directors on the compensation committee of corporate 

boards. But that is a fallacy. First of all, investors can only vote for, not against 

a director in the system we have today. Second, some institutional investors have 

direct conflicts when voting as a result of receiving fees for managing corporate pension funds of the management they are voting on. At times this seems to unduly 

and improperly influence their votes. 

To remedy these shortcomings, Congress should move to adopt legislation that 

would: 

• Require majority voting for directors and those who can’t get a majority of the 

votes of investors they are to represent should be required to step down. 

• Require public issuers to annually submit their compensation arrangements to 

a vote of their investors—commonly referred to as ‘‘say on pay.’’ 

• Give investors who own 3 to 4 percent of the company, the same equal access 

to the proxy as management currently has. While some argue this will give special interests an ability to railroad corporate elections, that simply has proven 

not to be the case. When special interests have tried to mobilize votes based 

on their interests and not those of investors, they have ALWAYS failed miserably. 

• Investors who own 5 percent or more of the stock of a company should be permitted, as they are in other countries, to call for a special meeting of all investors. They should also be given the right to do so to call for a vote on reincorporation when management and corporate boards unduly use state laws detrimental to shareholder interests to entrench themselves further. 

• Strengthen the fiduciary requirements of institutional investors when voting on 

behalf of those whose money they manage. This should extend to all such institutional investors including mutual funds, hedge funds, public and corporate 

pension funds as well as the labor pension funds. 

Since voting is an integral part of and critically important to governance, greater 

oversight should be put in place with respect to those entities who advise institutions on how they should vote. Recently a paper from the Milstein Center for Governance and Performance at Yale has made recommendations in this regard as well. 

As a former managing director of one such entity, I would support legislation that 

would: 

• Require these entities to register with the SEC as investment advisors, subject 

to inspection by the SEC. While some have registered, others have chosen not 

to. 

• Require these entities to improve their transparency by disclosing their voting 

recommendations within a reasonable time period after the vote. 

• Require all institutional investors, including public, corporate, hedge and labor 

pension funds to disclose their votes, just as mutual funds are currently required to disclose their votes. 

• Require that only the legal owner of a share of stock can vote it, prohibiting 

those who borrow stock to unduly influence an election by voting borrowed stock 

they don’t even own, and eliminating broker votes. 

It should also be made explicit that the SEC has authority to set governance 

standards for the mutual funds. For example, the SEC should have the authority, 

and act on that authority, to require a majority of independent directors for mutual 

funds, as well as an independent chair. 

Investor’s rights of private actions have also been seriously eroded in the past decade. Certainly we should not return to the abuses of the court system that existed 

before the Private Securities Law Reform Act (PSLRA) was passed. But at the same 

time, investors should not have to suffer the type of conduct that contributed to 

Enron and other scandals. And the SEC does not, and will not have the resources 

to enforce the securities laws in all instances. 

The SEC should continue to be supportive of investors’ private right of action. The 

SEC should also continue to support court rulings that permit private investors to 

bring suits in the event of aiding and abetting and scheme liability. In 2004, the 

SEC filed an amicus brief in Simpson v. Homestore.com, Inc., upholding liability 

against an individual regardless of whether or not the person made false or misleading statements. In 2007, a request from SEC Commissioners to the Solicitor 

General to submit a brief in favor of upholding scheme liability in the case of 

Stoneridge v. Scientific-Atlanta was denied by the White House, despite the urging 
228 

of Senate Banking Committee Chairman Christopher Dodd (D-CT) and House Financial Services Committee Chairman Barney Frank (D-MA). The SEC needs to reclaim the SEC’s role of providing strong support for the right of investors to seek 

a private remedy. 

Investors in securities fraud cases have always had the burden of proving that 

defendants’ fraud caused the investors’ losses. Congress continued this policy in 

PSLRA. However, recent lower-court interpretations of a 2005 Supreme Court case 

have improperly transformed loss causation into an almost impossible barrier for investors in serious cases of fraud. Congress, with the support of the SEC, should act 

to fix the law in this area. 

Taking advantage of the loophole in the law the courts have now created, public 

companies have begun gaming the system. Specifically, corporations may now simultaneously disclose other information—positive and negative—in order to make their 

adverse disclosures ‘‘noisy,’’ so that attorneys representing shareholders will find it 

more difficult, if not impossible, to satisfy loss causation requirements. Other corporations may leak information related to the fraud, so that the share price declines 

at an early date, before they formally reveal the adverse news. 

In sum, narrow lower-court standards of loss causation are allowing dishonest 

conduct to avoid liability for fraudulent statements by disclosing that the corporation’s financial results have deteriorated without specifically disclosing the truth 

about their prior misrepresentations that caused the disappointing results. Insisting 

on a ‘‘fact-for-fact’’ ‘‘corrective disclosure’’ allows fraudsters to escape liability simply 

by not confessing. 

Transparency: The lack of credible financial information has done great damage 

to the capital markets. This has ranged from a lack of information on off balance 

sheet transactions as was the case with Enron, to a lack of information on the quality of assets on the balance sheets of financial institutions, to a lack of information 

on risk management at public entities, to a lack of transparency at regulators. 

The lack of transparency begins with accounting standards that yet again have 

failed to provide the markets and investors with timely, comparable and relevant 

information. The off balance sheet transactions that expose great risk to the markets, have once again been permitted to be hid from view by the accounting standard setters. What is more disturbing about this is that the standard setters were 

aware of these risks and failed to act. 

To remedy this serious shortcoming, and ensure the standard setters provide a 

quality product to investors and the markets, I believe Section 108 of SOX should 

be amended. It should require that before the SEC recognizes an accounting standard setter for the capital markets, either from the U.S. or internationally, that its 

board of trustees and voting board members must have preferably a majority of representatives from the investor community and certainly no less than 40 percent of 

their membership should be investors with adequate skills and a demonstrated ability to serve the public. In addition, any standard setter should be required to have 

an independent funding source before their standards are used. And finally, each 

standard setter should be required to periodically reevaluate the standards they 

have issued, and publicly report on the quality of their implementation. For too long 

accounting standard setters have disavowed any responsibility for their standards 

once they have been issued, a practice that should come to an immediate halt. 

The SEC also needs to closely monitor the current efforts of the FASB and International Accounting Standards Board (IASB) to ensure appropriate transactions are 

brought on balance sheet when a sponsoring company controls, or effectively controls the economics of the transaction. I fear based on developments to date, these 

efforts may yet once again fail investors. 

Transparency of the regulators needs to be enhanced as well so as to establish 

greater accountability. For example, the regulators should be required in their annual reports to Congress to: 

• Identify key risks that could affect the financial markets and participants they 

regulate, and discuss the actions they are taking to mitigate those risks. For 

example, the OCC and SEC have had risk management offices for some time, 

yet their reports have failed to adequately alert Congress to the impending disaster that has now occurred. Unfortunately the SEC risk management office 

was reduced to a staff of one. 

• They should have to provide greater detail as to their enforcement actions including the aggregate number and nature of the actions initiated, the number 

of actions in the pipeline and average age of those cases, the number and nature of the cases resolved and how those cases were resolved (e.g., litigation, 

settlement, case dismissed). 
229 

• Banking and securities regulators should be required to make public their examination reports. The public should be able to see in a transparent fashion 

what the regulator has found. Regulators who have found problems have all too 

often failed to disclose their findings of problems to the unsuspecting public or 

Congress. In some instances, the problems identified have not been promptly 

addressed by the regulator and have resulted in the need for taxpayer bailouts 

amounting to hundreds of billions of dollars. That simply should not be allowed 

to occur. And while some in the industry and banking regulators have indicated 

such disclosure could harm a financial institution, I believe any such harm is 

questionable and certainly of much less significance than the damage now being 

wrought on our economy and society. 

The securities and banking regulators should also be required to adopt greater 

disclosures of risks that can impact the liquidity and capital of financial institutions. 

The Shipley Working Group encouraged such disclosures. These disclosures should 

include greater information regarding the internal ratings, risks and delinquencies 

with respect to loans held by financial institutions. In addition, greater disclosures 

should be required regarding how a company identifies and manages risk, and 

changing trends in those risks, with an eye to the future. 

Improve Independence and Oversight of Self Regulatory Organizations: FINRA has 

been a useful participant in the capital markets. It has provided resources that otherwise would not have been available to regulate and police the markets. Yet serious questions have arisen that need to be considered when improving the effectiveness and efficiency of self regulation. 

Currently the Board of FINRA includes representatives from those who are being 

regulated. This is an inherent conflict and raises the question of whose interest the 

Board of FINRA serves. To address this concern, consideration should be given to 

establishing an independent board, much like what Congress did when it established the PCAOB. 

In addition, the arbitration system at FINRA has been shown to favor the industry, much to the detriment of investors. While arbitration in some instances can be 

a benefit, in other situations it has been shown to be costly, time consuming, and 

biased towards those who are constantly involved with it. Accordingly, FINRA’s system of arbitration should be made optional, and investors given the opportunity to 

pursue their case in a court of law if they so desire to do so. 

Finally careful consideration should be given to whether or not FINRA should be 

given expanded powers over investment advisors as well as broker dealers. FINRA’s 

drop in fines and penalties in recent years, and lack of transparency in their annual 

report to the public, raises questions about its effectiveness as an enforcement agency and regulator. And with broker dealers involved in providing investment advice, 

it is important that all who do so are governed by the same set of regulations, ensuring adequate protection for the investing public. 

Enforcement: With respect to enforcement of the securities laws, there are a number of steps Congress should take. After all, if laws are not adequately enforced, 

then in effect there is no law. 

Enforcement by the SEC would be enhanced if it were granted the power to bring 

civil and administrative proceedings for violations of 18 U.S.C. 1001, and seek civil 

money penalties therein. 18 U.S.C. 1001 is a criminal statute that provides, in pertinent part: 

in any matter within the jurisdiction of the executive, legislative, or judicial 

branch of the Government of the United States, knowingly and willfully— 

(1) falsifies, conceals, or covers up by any trick, scheme, or device a material fact; (2) makes any materially false, fictitious, or fraudulent statement 

or representation; or (3) makes or uses any false writing or document knowing the same to contain any materially false, fictitious, or fraudulent statement or entry; 

shall be fined under this title, imprisoned not more than 5 years or, if the 

offense involves international or domestic terrorism (as defined in section 

2331), imprisoned not more than 8 years, or both. 

The SEC should be authorized to prosecute criminal violations of the Federal securities laws where the Department of Justice declines to bring an action. When I 

was at the Commission, it made a number of criminal referrals, including such cases 

as the Sunbeam matter, which DOJ declined to advance because of resource constraints. Finally the SEC should be provided an ability to take actions for aiding 

and abetting liability under the Securities Act of 1933. The Commission can bring 

actions for aiding and abetting violations under the Securities Exchange Act of 

1934. 
230 

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. 

Finally, we have seen serious problems arise for those who have blown the whistle 

on corporate fraud. Despite the provisions of SOX designed to protect such individuals, regulatory interpretations of that law have rendered it meaningless all too 

often. Congress should fix these shortcomings, in part by giving jurisdiction over the 

law as it is applicable to the securities markets, to the SEC rather than the Department of Labor. 

Conclusion 

Improvements to the securities laws and regulations that will once again ensure 

investors can have confidence they are playing on a level playing field are critical 

to recovery of our capital markets and economy. Such legislative changes are necessary if a recovery is to occur, but it is equally important that when they are made, 

they are changes and improvements investors perceive as being credible and worthwhile. 

Thank you and I would be happy to answer any questions. 
231 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD 

FROM JOHN C. COFFEE, JR. 

Q.1. Transparency: Are there additional types of disclosures that 

Congress should require securities market participants to make for 

the benefit of investors and the markets? 

Also, would you recommend more transparency for investors: 

1. By publicly held banks and other financial firms of off-balance 

sheet liabilities or other data? 

2. By credit rating agencies of their ratings methodologies or 

other matters? 

3. By municipal issuers of their periodic financial statements or 

other data? 

4. By publicly held banks, securities firms and GSEs of their risk 

management policies and practices, with specificity and timeliness? 

A.1. Very simply, my answer is yes. In the case of financial institutions, recent experience has shown that, despite the Enron-era reforms, the major banks underwriting asset-backed securitizations 

entered into ‘‘liquidity puts’’ with preferred customers under which 

they agreed to repurchase those offerings if liquidity was lost in the 

secondary market—and they did not disclose these obligations on 

the face of their balance sheets. This was the same use of off balance sheet financing as Enron employed—all over again. Accounting regulators acquiesced to pressure from banks, and once again 

the result endangered the financial well being of the entire economy. 

Credit rating agencies should disclose their methodologies and 

assumptions (more or less as Senator Reed’s bill (S. 1073) would 

require). 

In general, financial institutions do need to provide better and 

more timely disclosure of risk management practices on a continuing basis. Here, rather than listing specific disclosures that 

should be made, I would suggest that Congress instruct the SEC 

to study the recent failures and tighten its disclosure requirements 

in light of such study. 

Q.2. Conflicts of Interest: Concerns about the impact of conflicts of 

interest that are not properly managed have been frequently raised 

in many contexts—regarding accountants, compensation consultants, credit rating agencies, and others. For example, Mr. Turner 

pointed to the conflict of the board of FINRA including representatives of firms that it regulates. The Millstein Center for Corporate 

Governance and Performance at the Yale School of Management in 

New Haven, Connecticut on March 2 proposed an industry-wide 

code of professional conduct for proxy services that includes a ban 

on a vote advisor performing consulting work for a company about 

which it provides recommendations. 

In what ways do you see conflicts of interest affecting the integrity of the markets or investor protection? Are there conflicts affecting the securities markets and its participants that Congress 

should seek to limit or prohibit? 

A.2. In particular, conflicts of interest have affected the practices 

of the credit rating agencies, as they both ‘‘consult’’ with issuers 
232 

and rate them, and only a thin (and possibly permeable) Chinese 

Wall separates the two functions and staffs. In addition, there is 

the problem of forum-shopping, as the issuer pays an initial fee to 

several agencies, but only uses the higher or highest ratings (after 

paying a second fee). 

Proxy advisors (including Risk Metrics) are similarly subject to 

the same conflicts of interest, as they also advise both their client 

base of institutional investors and issuers who specially hire them. 

At a minimum, such conflicts should be disclosed to investors along 

with all fees received by the proxy advisor from the issuer. 

Q.3. Credit Default Swaps: There seems to be a consensus among 

the financial industry, government officials, and industry observers 

that bringing derivative instruments such as credit default swaps 

under increased regulatory oversight would be beneficial to the nation’s economy. Please summarize your recommendations on the 

best way to oversee these instruments. 

A.3. The best response is to mandate the use of clearinghouses in 

the trading of over-the-counter derivatives. Such clearinghouses 

would in turn specify margin and mark-to-market procedures for 

such instruments, subject to the general oversight of the Fed or the 

SEC/CFTC (depending on the instrument). The industry will respond to this proposal by saying such a rule should only apply to 

‘‘standardized’’ derivatives. But there is no clear line between 

‘‘standardized’’ and ‘‘customized’’ derivatives, and good lawyers can 

make any derivative customized in about 10 minutes if it will enable the issuer to escape additional regulatory costs. Thus, Congress or the SEC must draw a careful line so as not to permit the 

clearinghouse requirement to be trivialized. 

Q.4. Corporate Governance—Majority Vote for Directors, Proxy Access, Say on Pay: The Council of Institutional Investors, which represents public, union and corporate pension funds with combined 

assets that exceed $3 trillion, has called for ‘‘meaningful investor 

oversight of management and boards’’ and in a letter dated December 2, 2008, identified several corporate governance provisions that 

‘‘any financial markets regulatory reform legislation [should] include.’’ Please explain your views on the following corporate governance issues: 

1. Requiring a majority shareholder vote for directors to be elected in uncontested elections; 

2. Allowing shareowners the right to submit amendment to 

proxy statements; 

3. Allowing advisory shareowner votes on executive cash compensation plans. 

A.4. I support the SEC’s proposals on access to the proxy statement 

and would require ‘‘say on pay’’ (i.e., an advisory shareholder vote 

on compensation) by legislation. I would urge Congress to expressly 

authorize the SEC to adopt its proposals on shareholder access to 

the proxy litigation, as otherwise there is certain to be litigation 

about the SEC’s authority. Nor is the outcome of this litigation free 

from doubt. With respect to majority voting, I do not think it is 

necessary to overrule state law by mandating majority voting on di-
233 

rectors, as the majority of the Fortune 1000 already follow this 

practice. 

Q.5. Credit Rating Agencies: Please identify any legislative or regulatory changes you believe are warranted to improve the oversight 

of credit rating agencies. 

In addition, I would like to ask your views on two specific proposals: 

1. The Peterson Institute report on ‘‘Reforming Financial Regulation, Supervision, and Oversight’’ recommended reducing 

conflicts of interest in the major rating agencies by not permitting them to perform consulting activities for the firms 

they rate. 

2. The G30 Report ‘‘Financial Reform; A Framework for Financial Stability’’ recommended that regulators should permit 

users of ratings to hold NRSROs accountable for the quality 

of their work product. Similarly, Professor Coffee recommended creating potential legal liability for recklessness 

when ‘‘reasonable efforts’’ have not been made to verify ‘‘essential facts relied upon by its ratings methodology.’’ 

A.5. I favor the provisions set forth in the Reed Bill (S. 1073) and 

in the more recent proposals made by the Bipartisan Policy Counsel’s Credit Rating Agency Task Force. I agree that the rating 

agencies face a conflict when they perform consulting services for 

companies that they rate. Liability for ‘‘recklessness’’ makes sense, 

but should be accompanied by a safe harbor that establishes clear 

standards that will enable the rating agency to avoid liability (as 

the Reed Bill does). Although Congress cannot resolve the First 

Amendment issues that the rating agencies raise in their defense, 

Congress can make legislative findings of fact (to which most 

courts do give deference) that find that credit ratings (particularly 

those on structured finance products) do not relate to matters of 

public concern and so do not merit constitutional protection beyond 

that normally accorded ‘‘commercial speech.’’ Finally, I would urge 

a statutory ceiling on the liability of a credit rating agency for any 

one rating or transaction, which ceiling would apply in both Federal and State court actions. 

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds Association testified before the House Subcommittee on Capital Markets 

and said: ‘‘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.’’ MFA supported the creation or designation of a ‘‘single 

central systemic risk regulator’’ that (1) has ‘‘the authority to request and receive, on a confidential basis, from those entities that 

it determines . . . 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,’’ (2) has 

a mandate of protection of the financial system, but not investor 

protection or market integrity and (3) has the authority to ensure 

that a failing market participant does not pose a risk to the entire 

financial system. 
234 

Do you agree with MFA’s position? Do you feel there should be 

regulation of hedge funds along these lines or otherwise? 

A.6. I agree with the MFA’s position. Systemic risk should be delegated to a different agency than the agency charged with consumer 

protection, as there are potential conflicts between these two roles. 

In short, a ‘‘twin peaks’’ model should be followed. Hedge funds are 

not inherently different than AIG in that any large financial institution could potentially fail in a manner that endangered counterparties and could therefore pose a systemic risk to the financial 

system. 

Q.7. Self-Regulatory Organizations: How do you feel the self-regulatory securities organizations have performed during the current 

financial crisis? Are there changes that should be made to the selfregulatory organizations to improve their performance? Do you feel 

there is still validity in maintaining the self-regulatory structure or 

that some powers should be moved to the SEC or elsewhere? 

A.7. Principally, I believe that pre-dispute arbitration agreements 

should be limited, as the process is often unfair to investors. Beyond that, the position of investment advisers, who have no SRO, 

is anomalous and should be re-examined. I express no view on 

whether they should form their own SRO or be brought under 

FINRA. 

In overview, the SROs did not cause (but did little to prevent) 

the 2008 financial crisis. Conceivably, they could have discovered 

Mr. Madoff’s fraud (but the SEC bears the greater responsibility). 

The SRO structure has some value, particularly because SROs are 

self-funding and can tax the industry. Also, they enforce ‘‘fair and 

equitable’’ rules that are far broader than the SEC’s typically narrower anti-fraud rules. 

Q.8. Structure of the SEC: Please share your views as to whether 

you feel that the current responsibilities and structure of the SEC 

should be changed. 

Please comment on the following specific proposals: 

1. Giving some of the SEC’s duties to a systemic risk regulator 

or to a financial services consumer protection agency; 

2. Combining the SEC into a larger ‘‘prudential’’ financial services regulator; 

3. Adding another Federal regulators’ or self-regulatory organizations’ powers or duties to the SEC. 

A.8. I do not believe that merging the SEC with another regulator 

is sensible or politically feasible in the short run. Nor do I think 

that the SEC should (at least over the short-run) assume any of the 

duties of other regulators. However, the SEC’s ‘‘Consolidated Supervised Entity’’ Program, which was begun in 2004, clearly failed 

in 2008 and should not in any form be re-created. Large financial 

institutions (such as Goldman, Sachs or Morgan Stanley) are better 

monitored by the Federal Reserve as Tier One Bank Holding Companies, and the capital markets have greater confidence in the 

Fed’s monitoring ability. 

Q.9. SEC Staffing, Funding, and Management: The SEC has a 

staff of about 3,500 full-time employees and a budget of $900 mil-
235 

lion. It has regulatory responsibilities with respect to approximately: 12,000 public companies whose securities are registered 

with it; 11,300 investment advisers; 950 mutual fund complexes; 

5,500 broker-dealers (including 173,000 branch offices and 665,000 

registered representatives); 600 transfer agents, 11 exchanges; 5 

clearing agencies; 10 nationally recognized statistical rating organizations; SROs such as the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board and the Public 

Company Accounting Oversight Board. 

To perform its mission effectively, do you feel that the SEC is appropriately staffed? funded? managed? How would you suggest that 

the Congress could improve the effectiveness of the SEC? 

A.9. The SEC needs more funds and more staff. This is best accomplished by making the SEC at least partially ‘‘self-funding,’’ specifically by allowing the SEC to keep the fees and other charges that 

it levies on issuers, brokers and other regulated entities. I would 

not, however, recommend that the SEC keep civil penalties and 

fines, as this would raise both due process and ‘‘appearance of justice’’ issues that are best avoided. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM JOHN C. COFFEE, JR. 

Q.1. Do you all agree with Federal Reserve Board Chairman 

Bernanke’s remarks today about the four key elements that should 

guide regulatory reform? 

First, we must address the problem of financial institutions that are deemed too 

big—or perhaps too interconnected—to fail. Second, we must strengthen what 

I will call the financial infrastructure—the systems, rules, and conventions that 

govern trading, payment, clearing, and settlement in financial markets—to ensure that it will perform well under stress. Third, we should review regulatory 

policies and accounting rules to ensure that they do not induce excessive 

procyclicality—that is, do not overly magnify the ups and downs in the financial 

system and the economy. Finally, we should consider whether the creation of 

an authority specifically charged with monitoring and addressing systemic risks 

would help protect the system from financial crises like the one we are currently experiencing. 

Would a merger or rationalization of the roles of the SEC and 

CFTC be a valuable reform, and how should that be accomplished? 

How is it that AIG was able to take such large positions that it 

became a threat to the entire financial system? Was it a failure of 

regulation, a failure of a product, a failure of risk management, or 

some combination? 

How should we update our rules and guidelines to address the 

potential failure of a systematically critical firm? 

A.1. Bernanke’s Comments: I would strongly agree with Chairman 

Bernanke’s above quoted remarks, and I believe that his final question about the desirability of a systemic risk regulator must be answered in the affirmative (although the identity of that regulators 

can be reasonably debated). The term ‘‘too big to fail’’ is a misnomer. In reality, a systemic risk regulator must have the authority to identify financial institutions that are ‘‘too interconnected to 

fail’’ and to regulate their capital structure and leverage so that 

they do not fail and thereby set off a chain reaction. 
236 

SEC/CFTC Merger: Although a merger of the SEC and the 

CFTC would be desirable, it is not an essential reform that must 

be accomplished to respond effectively to the current financial crisis 

(and it would be a divisive issue that might stall broader reform 

legislation). At most, I would suggest that jurisdiction over financial futures be transferred from the CFTC to the SEC. An even 

narrower transfer would be to give the SEC jurisdiction over single 

stock futures and narrow-based stock indexes. Over the counter derivatives might be divided between the two in terms of whether the 

derivative related to a security or a stock index (in which case the 

SEC would receive jurisdiction) or to something else (in which case 

the CFTC should have jurisdiction). 

The AIG Failure: AIG’s failure perfectly illustrates the systemic 

risk problem (because its failure could have caused a parade of falling financial dominoes). It also illustrates the multiple causes of 

such a failure. AIG Financial Products, Inc., the key subsidiary, 

was principally based in London and was the subsidiary of the parent of the insurance company. As a non-insurance subsidiary of an 

insurance holding company, it was beyond the effective oversight of 

the New York State Insurance Commissioner, and there is no Federal insurance regulator. Although AIG also owned a small thrift, 

the Office of Thrift Supervision (OTS) could not really supervise an 

unrelated subsidiary operating in London. Thus, this was a case of 

a financial institution that fell between the regulatory cracks. 

But it was also a case of a private governance failure caused by 

excessive and short-term executive compensation. The CEO of AIG 

Financial Products (Mr. Cassano) received well over a $100 million 

in compensation during a several year period between 2002 and 

2006. This gave him a strong bias toward short-term profit maximization and incentivized him to continue to write credit default 

swaps for their short term income, while ignoring the long term 

risk to AIG of a default (for which no reserves were established). 

Thus, there were both private and public failures underlying the 

AIG collapse. 

Procedures for Failure of a ‘‘Systematically Critical Firm’’: The 

Lehman bankruptcy will remain in the courts for a decade or more, 

with considerable uncertainty overhanging the various outcomes. 

In contrast, the FDIC can resolve a bank failure over a weekend. 

This suggests the superiority of a resolution-like procedure following the FDIC model, given the uncertainty and resulting potential for panic in the case of a failure of any major financial institution. Both the Bush and Obama Administrations have endorsed 

such a FDIC-like model to reduce the prospect of a financial panic. 

I note, however, that one need not bail out all counterparties at the 

level of 100 percent, as a lesser level of protection would avert any 

panic, while also leaving the counterparties with a strong incentive 

to monitor the solvency of their counterparty. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER 

FROM JOHN C. COFFEE, JR. 

Q.1. Are you concerned that too much reliance on investor protection through private right of action against the credit ratings agencies will dramatically increase both the number of law suits the 
237 

companies will have to deal with as well as their cost of doing business? Have you thought about alternative ways to ensure adequate 

investor protections that will not result in driving capital from the 

U.S. in the same way that the fear of litigation and costs created 

by Sarbanes-Oxley has resulted in a decline in new listings in 

American capital markets? 

A.1. I have two independent responses: First, authorizing a cause 

of action along the lines that Senator Reed’s bill (S. 1073—‘‘The 

Rating Accountability and Transparency Enhancement Act of 

2009’’) does should not increase the number or aggregate recoveries 

in securities litigation to any significant degree. This is because the 

Reed bill’s proposed cause of action against credit rating agencies 

contains an important safe harbor under which a credit rating 

agency that conducts due diligence or hires an independent due 

diligence firm will be protected against suit. In this light, I believe 

the real impact of this provision will be ex ante, rather than ex 

post, meaning that it will change the rating agency’s behavior so 

as to avert litigation, rather than affecting the overall incidence or 

outcome of suits against it. 

Secondly, I have elsewhere proposed that all securities litigation 

against secondary defendants (i.e., persons other than the issuer or 

underwriter) be subject to a ceiling on damages to protect against 

such litigation causing their insolvency. So limited, securities litigation against secondary participants could deter, but not destroy. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD 

FROM T. TIMOTHY RYAN, JR. 

Q.1. Transparency: Are there additional types of disclosures that 

Congress should require securities market participants to make for 

the benefit of investors and the markets? 

Also, would you recommend more transparency for investors: 

1. By publicly held banks and other financial firms of off-balance 

sheet liabilities or other data? 

2. By credit rating agencies of their ratings methodologies or 

other matters? 

3. By municipal issuers of their periodic financial statements or 

other data? 

4. By publicly held banks, securities firms and GSEs of their risk 

management policies and practices, with specificity and timeliness? 

A.1. We do not believe that there are ‘‘additional types of disclosures’’ that should be required regarding participants in the capital 

markets. The disclosures currently required in financial statements 

have increased substantially over the last decade and in particular 

over the last year, and have led some commentators to observe that 

re-organizing current mandated disclosures might result in a more 

concise but more intelligible set of disclosures for readers of financial statements. We think that such an approach would be more 

beneficial than simply increasing the amount of data required. 

Both FASB and the SEC have recognized the need for additional 

disclosure regarding off-balance sheet exposures. Those requirements will be phasing in over the course of this year and we be-
238 

lieve will meaningfully increase the amount of information in the 

marketplace regarding off-balance sheet assets and liabilities. 

Last year, SIFMA formed a global, investor-led task force to 

identify and examine key issues related to the credit ratings paradigm. SIFMA’s Credit Rating Agency Task Force issued its recommendations last July. These recommendations included the following related to disclosure: 

• CRAs should provide enhanced, clear, concise, and standardized disclosure of CRA rating methodologies; 

• CRAs should disclose results of due diligence and examination 

of underlying asset data examinations, and limitations on 

available data, as well as certain other information relied upon 

by the CRAs in the ratings process; 

• CRAs should provide disclosure of CRA surveillance procedures; this will foster transparency, and allow market users of 

ratings to understand their bases and limitations; 

• CRAs should provide access to data regarding CRA performance; this will allow investors to assess how CRAs differ both 

in the performance of their initial ratings, and in their ongoing 

surveillance of existing ratings; and 

• CRA fee structures, and identities of top payors, should be disclosed by CRAs to their regulators. 

The report discusses these recommendations in detail. A copy of 

the report is attached and can also be found at http:// 

www.sifma.org/capitallmarkets/docs/SIFMACRARecommendations.pdf 

Municipal issuers are already required to provide annual financial statements and material event notice disclosures to investors 

pursuant to SEC Rule 15(c)2-12, and plans are underway for this 

information to be more easily accessed under the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access system (EMMA). As of July 1, 2009, EMMA will be the new central 

filing repository for municipal issuer annual financial statements 

and material events notices as well as a free Internet-based transparency vehicle for retail investors seeking this information. 

The current disclosure requirements already encompass a great 

deal of information on the risk management policies/practices of 

banks and securities firms, particularly in the MD&A of financial 

statements. While improvements in the presentation and intelligibility of such disclosures may occur as a result of preparer interaction with investors, analysts, and other users of financial statements, we do not believe that at this point additional requirements 

per se are warranted. 

Q.2. Conflicts of Interest: Concerns about the impact of conflicts of 

interest that are not properly managed have been frequently raised 

in many contexts—regarding accountants, compensation consultants, credit rating agencies, and others. For example, Mr. Turner 

pointed to the conflict of the board of FINRA including representatives of firms that it regulates. The Millstein Center for Corporate 

Governance and Performance at the Yale School of Management in 

New Haven, Connecticut on March 2 proposed an industry-wide 

code of professional conduct for proxy services that includes a ban 
239 

on a vote advisor performing consulting work for a company about 

which it provides recommendations. 

In what ways do you see conflicts of interest affecting the integrity of the markets or investor protection? Are there conflicts affecting the securities markets and its participants that Congress 

should seek to limit or prohibit? 

A.2. SIFMA agrees that effective management of conflicts of interest by market intermediaries builds confidence in the integrity of 

financial markets and promotes investor protection. We generally 

support initiatives to identify and manage conflicts and we believe 

the industry has made significant steps over the past several years 

to develop best practices in this area. For example, our members 

have developed an ‘‘Investor’s Bill of Rights’’ which states that each 

investor has the right ‘‘to be apprised of significant conflicts of interest identified in a financial relationship between an investor and 

his or her broker-dealer or account representative.’’ This resource 

is available at http://www.sifma.org/privatelclient/pdf/ 

SIFMAlInvestorRights.pdf. In another example, our members 

have also developed ‘‘Principles for Managing the Distributor-Individual Relationship’’ for structured products that includes guidance 

on managing potential conflicts. This resource is available at 

http://www.sifma.org/privatelclient/pdf/GlobalRSPDistributorPrinciplesFinal.pdf. Similarly, our proposed universal standard of 

care for retail investors, would also require financial professionals 

to provide full and fair disclosure of all material facts, including 

material conflicts of interest. 

Q.3. Credit Default Swaps: There seems to be a consensus among 

the financial industry, government officials, and industry observers 

that bringing derivative instruments such as credit default swaps 

under increased regulatory oversight would be beneficial to the nation’s economy. Please summarize your recommendations on the 

best way to oversee these instruments. 

A.3. Credit default swaps are important financial tools that allow 

companies across America access to capital at lower cost by allowing banks to efficiently hedge exposure to debt of these companies. 

We believe there is wide agreement that steps should be taken to 

address issues that have arisen in connection with CDS and other 

derivatives, but care should be taken not to impair the usefulness 

of these products. In particular, as recognized by the President’s 

Working Group, market participants should be allowed to enter 

into customized bilateral contracts in order to accomplish their risk 

management objectives. We believe that Congress should consider 

subjecting all systemically significant participants in derivatives 

markets, whether they are investors or dealers, to oversight by a 

single Federal regulator with broad authority to identify who is 

systemically significant, to consult with industry and develop principles for prudent management of risk, to promulgate appropriate 

rules based on those principles, and to access information necessary to carry out its oversight responsibilities. Among other 

things, we believe the principles adopted by the systemic regulator 

should encourage submission of standardized credit default swaps 

to clearing houses that are subject to Federal regulatory oversight. 

This will help assure adequate collateral posting and decrease ag-
240 

gregate leverage in the financial system, both of which will reduce 

overall levels of risk. Because financial markets and the activities 

of major market participants are global, it is important that the 

Federal systemic risk regulator consult and coordinate with regulators in major markets outside of the United States. 

Q.4. Corporate Governance—Majority Vote for Directors, Proxy Access, Say on Pay: The Council of Institutional Investors, which represents public, union and corporate pension funds with combined 

assets that exceed $3 trillion, has called for ‘‘meaningful investor 

oversight of management and boards’’ and in a letter dated December 2, 2008, identified several corporate governance provisions that 

‘‘any financial markets regulatory reform legislation [should] include.’’ Please explain your views on the following corporate governance issues: 

1. Requiring a majority shareholder vote for directors to be elected in uncontested elections; 

2. Allowing shareowners the right to submit amendment to 

proxy statements; 

3. Allowing advisory shareowner votes on executive cash compensation plans. 

A.4. While requiring a majority shareholder vote for directors to be 

elected in uncontested elections may promote selection of wellqualified directors, SIFMA would note that for some issuers, this 

could be a difficult requirement to meet. The SEC is likely to prohibit brokerdealers from voting the uninstructed shares of clients 

in director elections in a current rulemaking project. SIFMA is concerned about protecting the privacy of those clients who object to 

direct contact with issuers. This will also increase costs for issuers 

who will need to spend significant sums to get out the vote. Finally, 

small issuers would likely be disadvantaged because their shares 

are more often held by retail investors rather than large, institutional investors. 

SIFMA does not have a position on this proposal but notes that 

the thresholds for when a shareholder or group of shareholders 

would be granted access to an issuer’s proxy should be high enough 

so that the process isn’t abused. The process for allowing shareholders to submit amendments to proxy statements would need to 

be clear and to minimize costs, uniform. It is very important that 

shareholders have the right to vote; the submission of amendments 

should not inhibit today’s efficient and timely process for the arrival of proxy statements. Building in time for amendments could 

further delay the transmission of proxy material, this and other 

practical issues presented by the proposal warrant careful consideration. 

As the Committee knows, a number of SIFMA members are subject to the TARP requirement to conduct an advisory shareowner 

vote on compensation. Several firms have either implemented this 

requirement or are working toward meeting it. We caution that the 

results of this year’s advisory votes may not be emblematic of potential future advisory votes. This year many of the TARP companies did not pay senior management any bonuses and it is quite 

possible that this factored heavily in the votes in favor. Also, many 
241 

TARP companies that implemented the advisory vote were required 

to do so in a hasty manner and as a result included the 

‘‘boilerplate’’ proposal language without thinking through what language made sense for their particular company. SIFMA has yet to 

take a position on whether annual advisory shareowner votes 

should be mandated for all public issuers as suggested by the 

Council of Institutional Investors or whether other mechanisms, 

such as issuer-specific surveys, would be more helpful to enhance 

communications between Boards and shareowners. 

Q.5. Credit Rating Agencies: Please identify any legislative or regulatory changes you believe are warranted to improve the oversight 

of credit rating agencies. 

In addition, I would like to ask your views on two specific proposals: 

1. The Peterson Institute report on ‘‘Reforming Financial Regulation, Supervision, and Oversight’’ recommended reducing 

conflicts of interest in the major rating agencies by not permitting them to perform consulting activities for the firms 

they rate. 

2. The G30 Report ‘‘Financial Reform; A Framework for Financial Stability’’ recommended that regulators should permit 

users of ratings to hold NRSROs accountable for the quality 

of their work product. Similarly, Professor Coffee recommended creating potential legal liability for recklessness 

when ‘‘reasonable efforts’’ have not been made to verify ‘‘essential facts relied upon by its ratings methodology.’’ 

A.5. Last year, SIFMA formed a global, investor-led task force to 

identify and examine key issues related to the credit ratings paradigm. SIFMA’s Credit Rating Agency Task Force issued its recommendations last July. A copy of the report is attached and can 

also be found at http://www.sifma.org/capitallmarkets/docs/ 

SIFMA-CRA-Recommendations.pdf. 

SIFMA’s CRA Task Force found that there is a perception by 

some that the degree and nature of interaction between CRAs and 

issuers during the ratings process may result in conflicts of interest. This perception undermines investor confidence in the accuracy 

and reliability of ratings. These perceived conflicts can arise both 

from the interaction between CRAs and issuers in the course of a 

CRA assigning a rating to a particular security, and from the 

CRAs’ provision of consulting or advisory services. 

The Task Force noted that each of five major CRAs (A.M. Best, 

DBRS, Fitch, Moody’s, and Standard & Poor’s) committed in their 

Joint Response to the IOSCO Consultation Report on the Role of 

Credit Rating Agencies in Structured Finance Markets to ‘‘plainly 

indicate’’ that it does ‘‘not and will not provide consulting or advisory services to the issuers the [CRA] rates.’’ 

In order to provide clarity to market participants, the Task Force 

recommended that ‘‘core’’ rating services be clearly defined by the 

CRAs and distinguished from such ‘‘consulting or advisory’’ services. The Task Force further recommended that CRAs clarify that 

‘‘consulting or advisory’’ services exclude other ‘‘ancillary’’ services 

provided to issuers and intermediaries in the ordinary course of 

business. 
242 

The Task Force viewed the CRAs’ permissible ‘‘core’’ services as 

including: 

1. the assignment and monitoring of public, private, and private 

placement ratings; 

2. issuance of credit estimates and hypothetical ratings, including requested Rating Evaluation Service and Rating Advisory 

Service (RES/RAS) services regarding issuer-proposed structures of hypothetical securities, indicative, or preliminary ratings, and impact assessments; 

3. hybrid securities assessment services; 

4. internal assessments; 

5. ratings coverage of project and infrastructure finance transactions and hybrid securities; 

6. dissemination of press releases and rating reports (that include the rating opinion); 

7. research reports and other publications, including methodologies, models, newsletters, commentaries, and industry studies; 

8. regular oral and written dialogue with issuers, intermediaries, 

investors, sponsors,regulators, legislators, trade organizations, 

and the media; and 

9. conducting and participating in conferences, speaking engagements, and educational seminars. 

In particular, the Task Force believes that these ‘‘core’’ services 

include the iterative process that occurs between an issuer, arranger, underwriter, and CRA during the rating of structured finance, project and infrastructure finance, and hybrid securities. 

The Task Force believes there is a misperception by some that 

this type of ‘‘core’’ interaction is essentially a consultation service 

by CRAs that gives rise to an insuperable conflict of interest, and 

which undermines the integrity and reliability of the resulting rating. As described above, however, the process of rating structured 

finance, project and infrastructure finance, and hybrid securities 

necessarily involves an iterative give-and-take between the issuer, 

arranger, underwriter, and CRA as part of the ‘‘core’’ services performed by the CRA. 

In light of this, the Task Force did not recommend placing limitations on this iterative process. Rather, the Task Force recommended that CRAs maintain an adequate governance structure 

that includes policies, procedures, mechanisms, and firewalls designed to minimize the likelihood that conflicts of interest will 

arise, and to manage the conflicts of interest that do arise. 

Similarly, ‘‘ancillary’’ services, in the view of the Task Force, are 

permissible rating-related services that are generally segregated by 

the CRA into separate business groups. The Task Force views examples of ‘‘ancillary’’ services as including, among others, market 

implied ratings (MIRS), KMV credit risk management, data services, credit risk solutions, and indices. 

SIFMA has not taken a position on legal liability for NRSROs. 

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds Association testified before the House Subcommittee on Capital Markets 

and said: ‘‘MFA and its members acknowledge that at a minimum 
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the hedge fund industry as a whole is of systemic relevance and, 

therefore, should be considered within the systemic risk regulatory 

framework.’’ MFA supported the creation or designation of a ‘‘single 

central systemic risk regulator’’ that (1) has ‘‘the authority to request and receive, on a confidential basis, from those entities that 

it determines . . . 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,’’ (2) has 

a mandate of protection of the financial system, but not investor 

protection or market integrity and (3) has the authority to ensure 

that a failing market participant does not pose a risk to the entire 

financial system. 

Do you agree with MFA’s position? Do you feel there should be 

regulation of hedge funds along these lines or otherwise? 

A.6. We support giving the financial markets stability regulator the 

authority to gather information from all U.S. financial institutions 

and markets in order to identify systemic risk and maintain financial stability. We believe this authority should apply to all financial 

institutions, regardless of charter, and regardless of whether they 

are currently functionally regulated or not, including hedge funds 

or private equity funds. One of the lessons learned from recent experience is that sectors of the market can be systemically important, even though no single institution in that sector is a significant player. The financial markets stability regulator will need information necessary to form and maintain a picture of the overall 

systemic risks in the U.S. financial system. The financial markets 

stability regulator should also have the authority, in consultation 

with any relevant Federal regulator, to make uniform rules to the 

extent necessary to reduce systemic risk and promote financial stability. 

As noted above, we have proposed that the financial markets stability regulator should probably have a more direct role in supervising systemically important financial institutions or groups. Such 

systemically important financial institutions or groups could include currently unregulated institutions, such as hedge funds or 

private equity funds, although we do not believe the financial markets stability regulator should become the functional regulator for 

such unregulated institutions. We agree with others that hedge 

funds should be regulated by a merged SEC and CFTC. 

Because we believe the financial markets stability regulator 

should have the authority to address a financial crisis, we believe 

such a regulator should have certain resolution powers, including 

the authority to appoint itself or another Federal regulatory agency 

as the conservator or receiver of any systemically important financial institution or group. 

Q.7. Self-Regulatory Organizations: How do you feel the self-regulatory securities organizations have performed during the current 

financial crisis? Are there changes that should be made to the selfregulatory organizations to improve their performance? Do you feel 

there is still validity in maintaining the self-regulatory structure or 

that some powers should be moved to the SEC or elsewhere? 

A.7. The SRO structure remains a viable regulatory framework. 

Supplemented by government oversight, this tiered regulatory sys-
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tem can provide a greater level of investor protection than the government alone might be able to achieve. Self-policing by professionals who have the requisite working knowledge and expertise 

about both marketplace intricacies and the technical aspects of regulation creates a self-regulatory system with valuable checks and 

balances. SRO performance may be improved by eliminating duplicative regulation, filling regulatory gaps, and harmonizing standards that are appropriately applicable to all investment services 

providers. In harmonizing standards, however, we note that just as 

one size does not fit all broker-dealers, it also does not fit all market users. There is a world of difference between an individual investor seeking to invest his/her retirement savings and a multi-billion dollar hedge fund implementing a sophisticated trading strategy. Indeed, there is a similar difference between a high net worth 

individual managing substantial assets and retail market participants seeking to save for college. While all participants must be 

protected from fraud, we need a flexible regulatory structure that 

can differentiate between the various types of market participants 

when it comes to mandatory prophylactic rules and requirements. 

Q.8. Structure of the SEC: Please share your views as to whether 

you feel that the current responsibilities and structure of the SEC 

should be changed. 

Please comment on the following specific proposals: 

1. Giving some of the SEC’s duties to a systemic risk regulator 

or to a financial services consumer protection agency; 

2. Combining the SEC into a larger ‘‘prudential’’ financial services regulator; 

3. Adding another Federal regulators’ or self-regulatory organizations’ powers or duties to the SEC. 

A.8. We have testified that we are in support of a merger of the 

SEC and the CFTC. The longstanding focus of the SEC has been 

investor protection, and we believe that this should continue to be 

so with any regulatory reform. We do not see a systemic risk regulator taking over any of the SEC’s duties; rather, such a regulator 

would work with existing Federal functional regulators such as the 

SEC. For example, we agree with others that hedge funds should 

be regulated by a merged SEC and CFTC. 

The SEC’s investor protection mandate could be expanded to 

other areas or products, and so we do not see the need for a separate financial services consumer protection agency for that purpose. 

On the other end of the spectrum, we do not see support for moving 

to an FSA-type model of a single prudential financial services regulator. Certain inefficiencies that result from the regulation of activities by the states and the SEC could be eliminated by vesting 

the regulatory authority for those activities in the SEC. 

Q.9. SEC Staffing, Funding, and Management: The SEC has a 

staff of about 3,500 full-time employees and a budget of $900 million. It has regulatory responsibilities with respect to approximately: 12,000 public companies whose securities are registered 

with it; 11,300 investment advisers; 950 mutual fund complexes; 

5,500 broker-dealers (including 173,000 branch offices and 665,000 

registered representatives); 600 transfer agents, 11 exchanges; 5 
245 

clearing agencies; 10 nationally recognized statistical rating organizations; SROs such as the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board and the Public 

Company Accounting Oversight Board. 

To perform its mission effectively, do you feel that the SEC is appropriately staffed? funded? managed? How would you suggest that 

the Congress could improve the effectiveness of the SEC? 

A.9. If the SEC is to take on a greater responsibility with respect 

to the regulation of hedge funds and other private equity vehicles, 

we believe that current staffing levels are inadequate. The SEC is 

currently unable to examine investment advisers in a timely manner, and with enhanced responsibilities their resources will be even 

more stretched. As a result, we believe additional funding of the 

SEC will be necessary. We would also support an internal reorganization of the SEC such that the examination functions, such as 

broker-dealer and investment adviser examinations, are combined 

with, and reporting into, the policy making units, so that the SEC 

speaks and acts consistently on policy issues. 
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RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM T. TIMOTHY RYAN, JR. 

Q.1. Do you all agree with Federal Reserve Board Chairman 

Bernanke’s remarks today about the four key elements that should 

guide regulatory reform? 

First, we must address the problem of financial institutions that are deemed too 

big—or perhaps too interconnected—to fail. Second, we must strengthen what 

I will call the financial infrastructure—the systems, rules, and conventions that 

govern trading, payment, clearing, and settlement in financial markets—to ensure that it will perform well under stress. Third, we should review regulatory 

policies and accounting rules to ensure that they do not induce excessive 

procyclicality—that is, do not overly magnify the ups and downs in the financial 

system and the economy. Finally, we should consider whether the creation of 

an authority specifically charged with monitoring and addressing systemic risks 

would help protect the system from financial crises like the one we are currently experiencing. 

A.1. We agree with Chairman Bernanke’s remarks and support the 

proposal to establish a financial markets stability regulator. At 

present, no single regulator (or collection of coordinated regulators) 

has the authority or the resources to collect information systemwide or to use that information to take corrective action across all 

financial institutions and markets regardless of charter. The financial markets stability regulator will help fill these gaps. 

We have proposed that the financial markets stability regulator 

should have authority over all financial institutions and markets, 

regardless of charter, functional regulator or unregulated status, 

including the authority to gather information from all financial institutions and markets, and to make uniform regulations related to 

systemic risk. This could include review of regulatory policies and 

rules to ensure that they do not induce excessive procyclicality. 

We have proposed that the financial markets stability regulator 

should probably have a more direct role in supervising systemically 

important financial institutions or groups. This would address the 

risks associated with financial institutions that may be deemed 

‘‘too big to fail.’’ Such systemically important financial institutions 

or groups could also include primary dealers, securities clearing 

agencies, derivatives clearing organizations and payment system 

operators, which would help strengthen the financial infrastructure, another key element of Chairman Bernanke’s proposal for 

regulatory reform. 

Q.2. Would a merger or rationalization of the roles of the SEC and 

CFTC be a valuable reform, and how should that be accomplished? 

A.2. We have testified that we are in support of a merger of the 

SEC and the CFTC. The U.S. is the only jurisdiction that splits the 

oversight of securities and futures activities between two separate 

regulatory bodies. When the CFTC was formed, financial futures 

represented a very small percentage of futures activity. Now, an 

overwhelming majority of futures that trade today are financial futures. These products are nearly identical to SEC regulated securities options from an economic standpoint, yet they are regulated by 

the CFTC under a very different regulatory regime. This disparate 

regulatory treatment detracts from the goal of investor protection. 

An entity that combines the functions of both agencies could be better positioned to apply consistent rules to securities and futures. 

We would support legislation to accomplish such a merger. 
270 

Q.3. How is it that AIG was able to take such large positions that 

it became a threat to the entire financial system? Was it a failure 

of regulation, a failure of a product, a failure of risk management, 

or some combination? 

A.3. We believe the problems at AIG resulted from a combination 

of several factors. Its affiliate, AIG Financial Products, sold large 

amounts of credit protection in the form of credit default swaps on 

collateralized debt obligations with exposure to subprime mortgages, without hedging the risk it was taking on. At the same time, 

AIG’s top credit rating gave many of its counterparties a false 

sense of security. Accordingly, many of the CDS agreements it negotiated provided that AIG would not be required to post collateral 

so long as it maintained a specified credit rating. AIG apparently 

believed its credit rating would never be downgraded, which enabled it to ignore the risk it would ever have to post collateral. 

Moreover, AIG appears to have under-estimated the default risk of 

the CDOs on which it sold credit protection, thus underestimating 

the size of its obligation to post large amounts of collateral in the 

event of its credit rating downgrade. While others might have made 

similar errors, it seems AIG in particular did not adequately account for the correlation of default risk among the different geographic areas where the mortgage assets underlying the CDOs 

originated. The market value of those CDOs fell by much more 

than AIG anticipated, leading to much greater collateral demands 

than it could possibly meet. It also appears that AIG Financial 

Products was not subject to adequate, effective regulatory oversight. All these factors are specific to AIG; its problems did not result from an inherent defect in CDS as a product. 

Q.4. How should we update our rules and guidelines to address the 

potential failure of a systematically critical firm? 

A.4. One of the most important gaps exposed during the current financial crisis was the lack of Federal resolution powers for systemically important financial groups. We believe that the proposed financial stability regulator should have the authority to appoint 

itself or another Federal regulatory agency as the conservator or 

receiver of any systemically important financial institution and all 

of its affiliates. Such conservator or receiver should have resolution 

powers similar to those contained in Sections 11 and 13 of the Federal Deposit Insurance Act. But because the avoidance powers, priorities and distribution schemes of the FDIA are very different 

from those in the Bankruptcy Code or other specialized insolvency 

laws that would otherwise apply to various companies in a systemically important financial group, the proposed resolution authority 

needs to be harmonized with the Bankruptcy Code and such other 

laws to avoid disrupting the reasonable expectations of creditors, 

counterparties and other stakeholders. Otherwise, the new resolution authority itself could create legal uncertainty and systemic 

risk. 

The Treasury’s proposed resolution authority for systemically significant financial companies is a good first start, but its scope 

needs to be expanded to apply to all of the companies that comprise 

a systemically important financial group while the gap between its 

substantive provisions and those in the Bankruptcy Code and other 
271 

1See Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Florence Harmon, Acting Secretary, U.S. Securities and Exchange Commission, dated July 25, 2008; 

Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Elizabeth M. 

Murphy, Secretary, U.S. Securities and Exchange Commission, dated March 26, 2009. 

specialized insolvency codes that would otherwise apply needs to be 

reduced in order to protect the reasonable expectations of creditors, 

counterparties and other stakeholders. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD 

FROM PAUL SCHOTT STEVENS 

Q.1. Transparency: Are there additional types of disclosures that 

Congress should require securities market participants to make for 

the benefit of investors and the markets? Also, would you recommend more transparency for investors: 

• By publicly held banks and other financial firms of off-balance 

sheet liabilities or other data? 

• By credit rating agencies of their ratings methodologies or 

other matters? 

• By municipal issuers of their periodic financial statements or 

other data? 

• By publicly held banks, securities firms and GSEs of their risk 

management policies and practices, with specificity and timeliness? 

A.1. Investment companies provide extensive disclosures and are 

highly transparent, especially as compared to many other investment products. As investors, investment companies generally favor 

efforts to increase transparency in the securities markets, unless 

countervailing policy objectives dictate otherwise or the information 

would not be meaningful to investors. 

Two specific areas in which ICI believes additional disclosure 

should be required are credit rating agencies and municipal securities. We strongly supported the Securities and Exchange Commission’s recent credit rating agency proposals—which would impose 

additional disclosure, reporting, and recordkeeping requirements on 

rating agencies for rating structured finance products—as an important first step to restoring investor confidence in the integrity 

of credit ratings and, ultimately, the market as a whole. We believe, however, that more must be done to increase disclosure and 

transparency not only in the area of structured finance products 

but also with respect to other debt securities, particularly municipal securities. We have urged the SEC to expand many of its proposed requirements for credit rating agencies to include these additional categories of securities, and to support legislation that would 

extend increased disclosure requirements to the issuers of these instruments. We also have recommended a number of additional disclosures to be made by rating agencies and issuers that should enhance disclosure for investors in a meaningful way. 1 We believe 

the SEC currently has authority to implement many of our recommendations. Others (such as the repeal of the Tower Amendment and certain changes to improve municipal securities disclosure, discussed below) would require Congressional action. 
272 

2See, e.g., Letter from Karrie McMillan, General Counsel, Investment Company Institute, to 

Florence Harmon, Acting Secretary, U.S. Securities and Exchange Commission, dated September 22, 2008. 

Rating Agency Disclosure: ICI recommends the following additional disclosures, which go beyond the SEC’s recent proposals, to 

improve the transparency of ratings and the rating process: 

• Rating agencies should be required to provide public disclosure 

of any material deviations between the credit rating implied by 

a rating model and the final credit rating issued. 

• Rating agencies should make more timely disclosure of their 

rating actions. 

• Rating agencies should disclose additional information regarding staffing issues, including personnel turnover and resource 

levels. 

• Rating agencies should disclose certain information about the 

ongoing review of their ratings. 

• Rating agencies should disclose additional information regarding rating stability, including when and how downgrades are 

conducted and the severity of potential downgrades. 

• Rating agencies should disclose additional information regarding conflicts of interest. 

• Rating agencies should be required to use standardized performance measurement statistics to facilitate comparability of 

these statistics. 

• Rating agencies should be required to conduct due diligence on 

the information they review to issue ratings and to provide related disclosure. 

We also recommend that the SEC apply these suggested disclosure requirements in a consistent manner to all types of rating 

agencies. In addition, to realize the full potential of a meaningful 

and effective disclosure regime, we recommend that the SEC require the standardized presentation of disclosure information in a 

presale report issued by the rating agencies. 

Municipal Securities Issuer Disclosure: ICI strongly urges Congress and the SEC to improve the content and timing of required 

disclosures regarding municipal securities. The Tower Amendment, 

adopted by Congress in 1975, prohibits the SEC and the Municipal 

Securities Rulemaking Board from directly or indirectly requiring 

issuers of municipal securities to file documents with them before 

the securities are sold. As we have stated numerous times, because 

of these restrictions, the disclosure regime for municipal securities 

is woefully inadequate, and the regulatory framework is insufficient for investors in today’s complex marketplace. 2

Legislative action regarding the Tower Amendment will be necessary to fully develop an adequate disclosure regime for municipal 

securities, including imposing certain disclosure requirements directly on municipal issuers. We would strongly support such action. 

We also recommend that Congress clarify the legal responsibilities 

of officials of municipal issuers for the disclosure documents that 

they authorize. In particular, Congress should spell out the responsibilities of underwriters with respect to municipal securities offer-
273 

3 ICI is not advocating a wholesale replication of the corporate disclosure framework for municipal securities. Instead, we are recommending a regulatory regime designed expressly for the 

needs of the municipal securities market. 4 Rule 15c2-12 under the Securities Exchange Act of 1934 currently requires information 

about municipal securities issuers to be provided only annually. In contrast, corporate issuers 

are subject to quarterly reporting requirements. Moreover, the rule does not provide any outside 

deadline for the disclosure of financial information, thus leaving the timing completely to the 

discretion of the issuer. As a result, investors often receive financial information anywhere from 

three months to twelve months, or even longer, following the end of a fiscal year. 5See Written Testimony of Elizabeth F. Mooney, CFA, CPA, Accounting Analyst, Capital 

Group Companies, before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, 

Subcommittee on Securities, Insurance, and Investment, Hearing on ‘‘Transparency in Accounting: Proposed Changes in Accounting for Off-Balance Sheet Entities’’ (September 18, 2008). 

ing statements and the responsibilities of bond counsel and other 

participants in municipal offerings. 

In the meantime, important steps can be taken to improve municipal securities disclosure without legislative action. In particular, ICI recommends that the SEC expand the list of information that is required to be disclosed under current SEC rules. 3 For 

example, the rule provision concerning notice of material events 

should be modified to more fully reflect the types of events that are 

material to today’s investors. These events should include, among 

others, material litigation or regulatory action, pending or threatened, or failure to meet any financial covenants contained in the 

bond documents (especially the failure to make any monthly/quarterly payments due under the bond documents). 

We also recommend changes to ensure that issuer financial information is provided to the public on a timely basis. 4 Specifically, the 

SEC should establish meaningful timeframes for the delivery of information required pursuant to the undertakings in an issuer’s continuing disclosure agreement. For example, issuers should be required to file financial reports within 180 days of the end of the 

fiscal year, instead of the more common practice of 270 days after 

fiscal year end. Also, if audited financial statements are not available within the recommended timeframe, issuers should be required to issue unaudited financials in the interim, as appropriate, 

in accordance with guidelines established by the National Federation of Municipal Analysts. Timely reporting would enhance the 

usefulness of the information reported, including by alerting investors to those issuers that may be experiencing problems that could 

affect the credit quality or other characteristics of their securities. 

Other Matters: In response to the question posed, ICI has no specific recommendations to offer regarding disclosure by publicly held 

banks or other financial institutions of off-balance sheet liabilities 

or other data. As a general matter, however, we would support additional transparency of off-balance sheet entities and activities. 

Such transparency should provide investment companies and other 

investors with important information about potential risk exposures faced by the companies in which they invest and should help 

avoid the market inefficiencies and other adverse consequences 

that the current lack of transparency has engendered. 5 We understand that the Financial Accounting Standards Board is working 

on revisions to two of its standards (FAS 140 and FIN 46) that are 

intended to address deficiencies in the accounting and disclosure of 

risks associated with off-balance sheet entities (e.g., structured investment vehicles) that were revealed during the current financial 
274 

crisis. We look forward to the implementation of these improvements. 

ICI likewise has no formal position on whether publicly held 

banks, securities firms, and GSEs should be required to disclose 

their risk management policies and practices. We would caution, 

however, that ‘‘risk management’’ means different things to different people and can also have varying connotations depending on 

the context. General disclosure would be of little value, and specific 

disclosure could create opportunities for exploitation. Disclosure describing policies and practices also would not convey how effective 

(or ineffective) any particular set of policies and practices are likely 

to be. Such disclosure therefore might create a false sense of security about an entity’s ability to cope with various risks. We do not 

intend to suggest that sound risk management policies and practices are not important; we merely question the usefulness of required public disclosure concerning such policies and practices. 

Q.2. Conflicts of Interest: Concerns about the impact of conflicts of 

interest that are not properly managed have been frequently raised 

in many contexts—regarding accountants, compensation consultants, credit rating agencies, and others. For example, Mr. Turner 

pointed to the conflict of the board of FINRA including representatives of firms that it regulates. The Millstein Center for Corporate 

Governance and Performance at the Yale School of Management in 

New Haven, Connecticut on March 2 proposed an industry-wide 

code of professional conduct for proxy services that includes a ban 

on a vote advisor performing consulting work for a company about 

which it provides recommendations. 

In what ways do you see conflicts of interest affecting the integrity of the markets or investor protection? Are there conflicts affecting the securities markets and its participants that Congress 

should seek to limit or prohibit? 

A.2. Conflicts of interest that are unknown or not properly managed can have a negative impact on financial markets and market 

participants. ICI agrees, therefore, that it is important to identify 

conflicts or potential conflicts and determine how they can best be 

addressed, including through regulation. The appropriate solution 

may vary depending on the nature and extent of the conflict as 

well as the context in which it arises. For example, sometimes disclosure can be an effective tool for addressing conflicts, by putting 

investors and the marketplace on notice and allowing them to 

evaluate the significance and impact of the conflict. In other circumstances, different measures may be called for, such as restricting or prohibiting conduct or transactions that present conflicts. 

The laws governing investment advisers and investment companies have employed both of these approaches. Under the Investment Advisers Act of 1940, an investment adviser must disclose 

conflicts to clients, and often must seek their consent to proceed 

with a transaction notwithstanding a conflict. By contrast, the Investment Company Act of 1940 addresses potential conflicts of interest in the context of investment company (fund) operations by 

prohibiting certain transactions between a fund and fund insiders 

or affiliated organizations (such as the corporate parent of the 

fund’s adviser). The Investment Company Act authorizes the Secu-
275 

6Likewise, a disclosure and consent model would be impracticable in the context of a pooled 

investment vehicle if each investor in the pooled vehicle were required to provide consent. 7 ICI believes that the SEC currently has authority under the Credit Rating Agency Reform 

Act of 2006 to implement the necessary regulatory reforms to address rating agency conflicts 

of interest. 8See Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Florence Harmon, Acting Secretary, U.S. Securities and Exchange Commission, dated July 25, 2008; 

Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Elizabeth M. 

Murphy, Secretary, U.S. Securities and Exchange Commission, dated March 26, 2009. 

rities and Exchange Commission (SEC) to grant exemptions by rule 

or order to the extent such exemptions are consistent with the underlying objectives of the statute. Pursuant to this authority, the 

SEC has issued exemptive rules and orders containing conditions 

designed to ensure that the interests of fund investors are amply 

protected. 

The restrictions on affiliated transactions under the Investment 

Company Act are widely viewed as a core investor protection and 

one that has served funds and their investors very well over nearly 

70 years. Congress may wish to consider whether it would be appropriate and beneficial to apply similar restrictions to other financial market participants or activities, coupled with exemptive authority similar to that granted to the SEC. At the same time, as 

noted above, ICI recognizes that this approach does not fit every 

situation that involves conflicts of interest. 6

While ICI does not have any specific legislative recommendations 

at this time regarding conflicts of interest that may affect the integrity of the markets or investor protection, we have commented 

extensively in the debate over possible regulatory actions to address conflicts of interest involving credit rating agencies—one of 

the issues mentioned in the question above. 7 We provide our comments on that topic below. 

The SEC has recently increased the list of conflicts of interest 

that must be disclosed and managed by rating agencies or, alternatively, that are prohibited. ICI supported these amendments but 

we believe that more should be done in this area. 8 We recommend 

that the SEC require additional disclosures by rating agencies regarding their conflicts of interest including, for example, the number of other products rated by a rating agency for a particular 

issuer. In addition, the SEC recently adopted a requirement that 

rating agencies disclose information regarding the conflict of being 

paid by certain parties to rate structured finance products. The targeted conflict of interest, however, is not confined to the ratings of 

these instruments. The disclosure requirement therefore should be 

extended to ratings of municipal securities. 

Public disclosure of conflict of interest information should improve transparency surrounding the information and processes 

used by rating agencies for rating products. It will provide users 

of ratings with a more complete picture of a rating agency’s rating 

process and expose that process to greater scrutiny. This exposure, 

in turn, should promote the issuance of more accurate, high-quality 

ratings, and could prevent rating agencies from being unduly influenced to produce higher than warranted ratings. It should also assist investors and other market professionals in performing an 

independent assessment of these products. To achieve these goals, 

it is critical that the SEC’s rules governing conflicts of interest be 

actively enforced and that rating agencies be held accountable for 
276 

9While the focus of the current debate has been on issuer-paid versus subscriber-paid models, 

we recognize that there may be other compensation models worthy of consideration that may 

better incentivize rating agencies to produce high quality ratings. For example, payment for 

public ratings could be linked to ‘‘quality provided’’ as determined by the end user—the investors. We believe these or other models should be subject to the same regulatory oversight as 

the more common issuer-paid and subscriber-paid models. 10To the extent that no Capital Markets Regulator is formed, we believe that the SEC is the 

regulator best suited to provide effective oversight of financial derivatives, including CDS. 

any failures to comply with the rules and their policies and procedures adopted under the rules. 

Moreover, to fully and properly address concerns about conflicts 

of interest, ICI believes the government should ensure that regulatory reforms for rating agencies are applied in a uniform and consistent manner equally to all types of credit rating agencies. Each 

type of rating agency business model—be it issuer-paid, subscriberpaid, or other 9—poses concerns and harbors conflicts of interest. 

Indeed, it is not clear that one model poses fewer risks of conflicts 

or invariably produces higher quality ratings. 

Q.3. Credit Default Swaps: There seems to be a consensus among 

the financial industry, government officials, and industry observers 

that bringing derivative instruments such as credit default swaps 

under increased regulatory oversight would be beneficial to the nation’s economy. Please summarize your recommendations on the 

best way to oversee these instruments. 

A.3. As we stated in our testimony, we believe that a single independent Federal regulator should be responsible for oversight of 

U.S. capital markets, market participants, and all financial investment products. We envision this ‘‘Capital Markets Regulator’’ as a 

new regulator that would encompass the combined functions of the 

Securities and Exchange Commission (SEC) and those of the Commodity Futures Trading Commission that are not agriculture-related. The Capital Markets Regulator should have express authority to regulate derivatives, including credit default swaps (CDS), including clear authority to adopt measures to increase transparency 

and reduce counterparty risk, while not unduly stifling innovation. 10

The current initiatives toward centralized clearing for CDS are 

a positive step in this regard. Central clearing of CDS should help 

reduce counterparty risk and bring transparency to trading in the 

types of CDS that can be standardized. We support these initiatives. 

Not all CDS are sufficiently standardized to be centrally cleared, 

however, and institutional investors will continue to need to conduct over-the-counter transactions in CDS. Accordingly, we do not 

support efforts to require the mandatory clearing of all CDS. We 

do support, however, reasonable reporting requirements for these 

CDS transactions in order to allow the Capital Markets Regulator 

to have enough data on the CDS market to provide effective oversight. 

Institutional market participants should also be required to 

make periodic public disclosure of their CDS positions. SEC registered investment companies currently make these types of periodic public disclosures. To the extent that registered funds buy or 

sell CDS, they provide extensive quarterly financial statement disclosures that typically include both textual note disclosure on the 
277 

11See FASB Staff Position No. 133-1 and FIN 45-4, Disclosures about Credit Derivatives and 

Certain Guarantees: An Amendment of FASB Statement No. 133 and FASB Interpretation No. 

45; and Clarification of the Effective Date of FASB Statement No. 161 (Sept. 12, 2008), available 

at http://fasb.org/pdf/fsplfas133-1&fin45-4.pdf 

nature and operation of CDS and tabular disclosure describing the 

terms of outstanding CDS at the report date. Textual note disclosures typically include: objectives, strategies, risks, cash flows, and 

credit events requiring performance. Tabular disclosures typically 

include: the reference entity, the counterparty, the pay/receive fixed 

rate, the expiration date, the notional amount, and the unrealized 

appreciation/depreciation (i.e., the fair value of the position). The 

Financial Accounting Standards Board (FASB) has recently taken 

steps to improve disclosures by the sellers of credit derivatives. 11

We fully supported that effort, and will continue to support similar 

initiatives that we believe will improve marketplace transparency 

in derivatives. 

Q.4. Corporate Governance—Majority Vote for Directors, Proxy Access, Say on Pay: The Council of Institutional Investors, which represents public, union and corporate pension funds with combined 

assets that exceed $3 trillion, has called for ‘‘meaningful investor 

oversight of management and boards’’ and in a letter dated December 2, 2008, identified several corporate governance provisions that 

‘‘any financial markets regulatory reform legislation [should] include’’ Please explain your views on the following corporate governance issues: 

1. Requiring a majority shareholder vote for directors to be elected in uncontested elections; 

2. Allowing shareowners the right to submit amendment to 

proxy statements; 

3. Allowing advisory shareowner votes on executive cash compensation plans. 

A.4. Investment companies (funds) are major shareholders in public companies and support strong governance and effective management of all companies whose shares they own. Funds typically are 

charged with seeking to maximize returns on behalf of fund investors, and they use a variety of methods to influence corporate conduct to this end. These methods include deciding whether to invest 

in a company, or to continue to hold shares; engaging directly with 

company management; and voting proxies for the shares they own. 

Since 2004, funds—alone among all institutional investors—have 

been required to publicly disclose their proxy votes. As a result of 

this unique disclosure requirement, the manner in which fund 

firms vote proxies has been intensely scrutinized, and critics have 

sought to politicize fund portfolio management. 

While critics have mischaracterized the data, the availability of 

fund voting records demonstrates how funds use the corporate 

franchise to promote the interests of their shareholders. ICI published a report last year on a study we conducted of more than 3.5 

million votes cast by funds in the 12-month period ended June 30, 

2007. Our report, Proxy Voting by Registered Investment Companies: Promoting the Interests of Fund Shareholders, made numerous important findings including, among others, that: (1) funds de-
278 

12The report is available at http://www.ici.org/stats/res/per14-01.pdf 13See Statement of Lynn E. Turner Before the Senate Committee on Banking, Housing, and 

Urban Affairs on Enhancing Investor Protection and the Regulation of the Securities Markets 

(March 10, 2009) at 13. 14See Siobhan Hughes, Rep. Frank Plans Hearing on Disclosure of Proxy Votes, Dow Jones 

News Service, March 22, 2007. 15 ICI has presented its views on this matter in Congressional testimony and in a comment 

letter to the SEC. See Statement of Paul Schott Stevens, President and CEO, Investment Company Institute, Before the Committee on Financial Services, United States House of Representatives on ‘‘SEC Proxy Access Proposals: Implications for Investors’’ (September 27, 2007); Letter 

from Karrie McMillan, General Counsel, Investment Company Institute, to Ms. Nancy M. Morris, Secretary, U.S. Securities and Exchange Commission, dated October 2, 2007, available at 

http://www.ici.org/statements/cmltr/07lseclproxylaccesslcom.html#TopOfPage 

vote substantial resources to proxy voting; (2) funds vote proxies in 

accordance with their board-approved guidelines; and (3) funds do 

not reflexively vote ‘‘with management,’’ as some critics claim, but 

rather make nuanced judgments in determining how to vote on 

both management and shareholder proposals. 12

ICI has recommended that Congress extend proxy vote disclosure 

requirements to other institutional investors, and we reiterate that 

recommendation here. Greater transparency around proxy voting 

by institutional investors should enhance the quality of the debate 

concerning how the corporate franchise is used. 

We are not the only proponents for increased transparency about 

the proxy votes of other institutional investors. Senator Edward M. 

Kennedy (D-MA) commissioned a 2004 GAO study entitled ‘‘Pension Plans: Additional Transparency and Other Actions Needed in 

Connection with Proxy Voting,’’ which concluded, among other 

things, that workers and retirees would benefit from increased 

transparency in proxy voting by pension plans. Similarly, in his 

testimony for the March 10, 2009, Senate Banking Committee 

hearing, former Securities and Exchange Commission Chief Accountant Lynn Turner expressed support for legislation to ‘‘require 

all institutional investors, including public, corporate and labor 

pension funds to disclose their votes, just as mutual funds currently are required to disclose their votes.’’ 13 House Financial Services Committee Chairman Barney Frank (D-MA) also has expressed interest in considering this issue. 14 If disclosure of proxy 

votes promotes important public policy objectives, then similar requirements should apply to all institutional investors. 

Below we provide our views on shareholder access to company 

proxy materials for director-related bylaw amendments and shareholder advisory votes on executive pay. 

Proxy Access: In their dual role as major, long-term investors in 

securities of public companies and as issuers with their own shareholders and boards of directors, funds have a valuable perspective 

to offer on the topic of shareholder access to company proxy materials and the need to appropriately balance the interests of shareholders with those of company management. ICI generally supports 

affording certain shareholders direct access to a company’s proxy 

materials for director-related bylaw amendments. 15 We agree that 

long-term shareholders with a significant stake in a company have 

a legitimate interest in having a voice in the company’s corporate 

governance. We believe that the ability to submit bylaw amendments concerning director nomination procedures could be an effec-
279 

tive additional tool for use by funds and others to enhance shareholder value. 

At the same time, the privilege of proxy access should not be 

granted lightly. The Federal securities laws should not facilitate efforts to use a company’s proxy machinery—at company expense— 

to advance parochial or short-term interests not shared by the company’s other shareholders. Instead, the regulatory scheme should 

be crafted to afford access to a company’s proxy only when the interests of shareholder proponents are demonstrably aligned with 

those of long-term shareholders. 

To achieve this objective, appropriate limits on the ability to use 

company resources to propose changes to a company’s governing 

documents are critically important. In our view, these limits should 

include: 

• Restricting the privilege of proxy access to shareholders who do 

not acquire or hold the securities for the purpose of changing 

or influencing control of the company. Shareholders seeking to 

change or influence control of the company should be required 

to follow the regulatory framework for proxy contests and bear 

the related costs. 

• Requiring shareholder proponents to demonstrate that they 

are long-term stakeholders with a significant ownership interest. We recommend that there be a meaningful required holding period, such as two years, to provide assurance that shareholder proponents are committed to the long-term mission of 

the company, rather than seeking the opportunity for personal 

gain and quick profits or advancement of parochial interests at 

the expense of the company and other shareholders. Similarly, 

we support establishing a relative high minimum ownership 

threshold that would encourage shareholders to come together 

to effect change. We believe a five percent ownership threshold 

may not be sufficiently high to assure that the company’s 

proxy machinery would be used to advance the common interests of many shareholders in addressing legitimate concerns 

about the management and operation of the company. Consideration should be given to varying the required ownership 

threshold based on factors such as the company’s market capitalization. The Securities and Exchange Commission (SEC) 

should study share ownership and holding period information 

to arrive at well-reasoned criteria that will encourage wouldbe shareholder proponents to work together to achieve goals 

that benefit all shareholders. 

• Excluding borrowed shares from the determination of ownership level and holding period. Beneficial ownership of shares 

should be required to assure that the proponents’ interests 

truly are aligned with those of long-term shareholders. 

Another important element of proxy access is disclosure. Shareholder proponents should be required to provide disclosure for inclusion in proxy materials that would allow a company’s other 

shareholders to make informed voting decisions (e.g., information 

about their background, intentions, and course of dealing with the 

company). SEC rules also should hold shareholder proponents—and 
280 

16See SEC Speech: Address to the Council of Institutional Investors, by Chairman Mary L. 

Schapiro, U.S. Securities and Exchange Commission (May 6, 2009), available at http:// 

www.sec.gov/news/speech/2009/spch040609mls.htm 

not companies—responsible for the disclosure those shareholders 

provide. 

SEC Chairman Mary Schapiro recently indicated that the SEC 

will soon consider a proposal ‘‘to ensure that a company’s owners 

have a meaningful opportunity to nominate directors.’’ 16 We look 

forward to reviewing and commenting on the SEC’s proposal. 

Say on Pay: As noted above, funds are significant holders of public companies. When deciding whether to invest in a company or to 

continue to hold its stock, funds consider many factors, including 

how the company compensates its top executives. This information 

is important because it allows funds to decide whether (1) there is 

an alignment of interests between the executives running the company and the shareholders who own the company and (2) executives have incentives to maximize value for shareholders. ICI has 

supported SEC efforts to ensure that investors receive clear and 

complete disclosure regarding executive pay packages. 

The financial crisis has fanned the flames of public outrage over 

executive compensation, particularly where such compensation appears to be grossly excessive in light of a company’s performance 

or where the compensation seems to promote the short-term interests of managers over the longer-term interests of shareholders. 

Funds are deeply mindful of these issues. ICI would not oppose requiring public companies to put the compensation packages of their 

key executive officers to a non-binding advisory vote of shareholders as an additional way to encourage sound decision-making 

by companies regarding the composition of executive pay packages. 

We strongly urge, however, that any such requirement be coupled with requiring other institutional investors to disclose their 

proxy votes, as we recommend above. Otherwise, the votes of funds 

on executive compensation, but not those of any other institutional 

investor, would be subject to scrutiny and, often we feel, unfair second-guessing. Moreover, the potential benefits of greater transparency of the proxy voting process would seem to be particularly 

evident here, where the public disclosure of executive compensation 

votes would maximize their influence over management. 

Q.5. Credit Rating Agencies: A. Please identify any legislative or 

regulatory changes you believe are warranted to improve the oversight of credit rating agencies. In addition, I would like to ask your 

views on two specific proposals: 

1. The Peterson Institute report on ‘‘Reforming Financial Regulation, Supervision, and Oversight’’ recommended reducing 

conflicts of interest in the major rating agencies by not permitting them to perform consulting activities for the firms 

they rate. 

2. The G30 Report ‘‘Financial Reform; A Framework for Financial Stability’’ recommended that regulators should permit 

users of ratings to hold NRSROs accountable for the quality 

of their work product. Similarly, Professor Coffee recommended creating potential legal liability for recklessness 
281 

17 ICI recently participated in the SEC’s Roundtable on the oversight of credit rating agencies 

in an effort to further the discussion on ways in which to improve ratings and the ratings process. See Statement of Paul Schott Stevens, President and CEO, Investment Company Institute, 

SEC Roundtable on Oversight of Credit Rating Agencies, dated April 15, 2009, available at 

http://www.ici.org/home/09loversightlstevenslstmt.html#TopOfPage. See also Statements of 

Paul Schott Stevens, President, Investment Company Institute, on the ‘‘Credit Rating Agency 

Duopoly Relief Act of 2005,’’ before the Committee on Financial Services, U.S. House of Representatives (November 29, 2005) and on ‘‘Assessing the Current Oversight and Operation of 

Credit Rating Agencies,’’ before the Committee on Banking, Housing, and Urban Affairs, U.S. 

Senate (March 7, 2006). 18See Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Florence Harmon, Acting Secretary, U.S. Securities and Exchange Commission, dated July 25, 2008; 

Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Elizabeth M. 

Murphy, Secretary, U.S. Securities and Exchange Commission, dated March 26, 2009. 19We believe the SEC currently has authority to implement many of our recommendations. 

Others (such as certain changes to improve municipal securities disclosure, discussed below) 

would require Congressional action. 

when ‘‘reasonable efforts’’ have not been made to verify ‘‘essential facts relied upon by its ratings methodology.’’ 

A.5. Measures To Improve the Oversight of Rating Agencies: ICI is 

committed to the objective of improving the rating process to make 

ratings more accurate and useful to investors and to promote the 

sound functioning of our capital markets. 17 We recommend several 

regulatory measures to enhance the oversight of credit rating agencies and thereby improve the quality, accuracy, and integrity of ratings and the rating process. 18 Generally speaking, our recommendations would enhance disclosure, address conflicts of interest, and hold rating agencies accountable for their ratings. 19

Specifically, we recommend that the Securities and Exchange 

Commission (SEC) improve disclosure about credit ratings and the 

rating process for structured finance securities and other debt securities. Public disclosure of information about a credit rating agency’s policies, procedures, and other practices relating to rating decisions will allow investors to evaluate more effectively a rating 

agency’s independence, objectivity, capability, and operations. Disclosure will serve as a powerful additional mechanism for ensuring 

the integrity and quality of the credit ratings themselves. To realize the full potential of such a disclosure regime, the SEC should 

require the standardized presentation of this information in a 

presale report issued by the rating agencies. 

The SEC also should take steps to strengthen the incentives to 

produce quality ratings, because such incentives are clearly insufficient in the current system. To this end, the SEC should require 

rating agencies to conduct ‘‘due diligence’’ assessments of the information they review to issue ratings. This should help build investor 

confidence in ratings and the rating process over time, by enabling 

users of ratings to gauge both the accuracy of the information being 

analyzed by the rating agency and the rating agency’s ability to assess the creditworthiness of the underlying security. We also recommend that rating agencies have greater legal accountability to 

investors for their ratings. Both of these recommendations should 

encourage rating agencies to improve the quality of their ratings. 

Today’s rating system is hampered by deep concerns about conflicts of interest, poor disclosure, and lack of accountability. To address these concerns effectively, the SEC should apply necessary 

regulatory reforms in a consistent manner to all types of credit rating agencies. A consistent approach is not only critical to improving 

ratings quality and allowing investors to identify and assess poten-
282 

20See Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Florence Harmon, Acting Secretary, U.S. Securities and Exchange Commission, dated September 22, 

2008. 21See Letter from Karrie McMillan, General Counsel, Investment Company Institute, to Florence Harmon, Acting Secretary, U.S. Securities and Exchange Commission, dated July 25, 2008. 22Section 11 under the Securities Act creates liability for issuers and certain professionals 

who prepared or certified any part of a registration statement for any materially false statements or omissions in the registration statement. 

tial conflicts of interest, but also to increasing competition among 

rating agencies. The SEC must also employ a consistent and active 

approach to enforcement of the oversight regime, holding rating 

agencies accountable for any failures to comply with the SEC’s 

rules and the rating agency’s own policies and procedures adopted 

under the rules. Finally, we recommend that the SEC address the 

need for better disclosure by certain issuers (e.g., expand issuer disclosure for structured finance products, expand and standardize 

issuer disclosure for asset-backed securities, and require that disclosure for asset-backed securities be ongoing). In addition, we recommend that the SEC improve issuer disclosure for municipal securities. 20 Better disclosure will assist investors in making their 

own risk assessments and should foster better quality ratings. 

Controlling Conflicts of Interest—Limiting or Prohibiting Consulting Activities: Addressing conflicts of interest at rating agencies 

is particularly important given the role that ratings play in today’s 

capital markets. For this reason, ICI has recommended that the 

SEC require rating agencies to disclose information, including: (1) 

any material ancillary business relationships between a rating 

agency and an issuer and (2) information regarding the separation 

of a rating agency’s consulting and rating activities. 21 If such information is available, we believe that it is unnecessary to prohibit 

rating agencies from performing any consulting activities for the 

firms they rate. The SEC already has prohibited rating agencies 

from rating a product in which the rating agency has been consulted on the structure of the product. We believe that this measure, in combination with the disclosure we have recommended, 

should curtail opportunities for questionable conduct. In addition, 

it should put investors on notice regarding potential conflicts of interest arising from a rating agency’s consulting business and provide investors with the information needed to assess the ability and 

effectiveness of a rating agency to manage those conflicts of interest. 

Enhancing Accountability, Due Diligence, and Legal Liability of 

Rating Agencies: Given the role of ratings in the investment process and the use of ratings by investors, ICI agrees with the recommendation in the G30 Report and by Professor Coffee: credit rating agencies should have greater legal accountability for their ratings. Currently, investors do not have sufficient legal recourse 

against rating agencies if, for example, a rating agency issues an 

erroneous rating. 

We believe that the exemption for nationally recognized statistical rating organizations (NRSROs) from Section 11 of the Securities Act of 1933 should be reconsidered. 22 Under current regulations, the SEC exempts NRSROs, but not other rating agencies, 

from treatment as experts subject to liability under Section 11 and, 

thus, allows NRSRO ratings in prospectuses and financial reports. 
283 

23 Rating agencies have cited the First Amendment in statements to Congress, the courts, and 

the investing public, stating that their ratings are opinions only—not ‘‘recommendations or commentary on the suitability of a particular investment.’’ See, e.g., Statement of Deven Sharma, 

President, Standard & Poor’s, on ‘‘Credit Rating Agencies and the Financial Crisis,’’ before the 

Committee on Oversight and Government Reform, U.S. House of Representatives (October 22, 

2008). See also Not ‘‘The World’s Shortest Editorial’’: Why the First Amendment Does Not 

Shield Rating Agencies From Liability for Over-Rating CDOs, David J. Grais and Kostas D. 

Katsiris, Grais & Ellsworth, Bloomberg Law Reports (November 2007). 24 Current rules only require that rating agencies provide a description of: (1) the public and 

nonpublic sources of information used in determining credit ratings, including information and 

analysis provided by third-party vendors; (2) whether and how information about verification 

performed on assets underlying structured finance securities is relied upon in determining credit 

ratings; and (3) whether and how assessments of the quality of originators of structured finance 

securities factor into the determination of credit ratings. 

Although the SEC has stated that NRSROs remain subject to antifraud rules, the NRSROs have steadfastly maintained that, under 

the First Amendment, they cannot be held liable for erroneous ratings absent a finding of malice. 

While it may be argued that rating agencies should not be liable 

for an erroneous rating as such, they should, at a minimum, have 

some accountability for ratings issued in contravention of their own 

disclosed procedures and standards. As we have stated in the past, 

even if the First Amendment applies to credit ratings, it should not 

immunize rating agencies for false or misleading disclosures to the 

SEC and to the investing public. Quite simply, if a rating agency 

obtains an NRSRO designation based on, for example, a specific 

ratings process, it should be held accountable to the SEC and to 

investors if it fails to follow that process. 

A rating agency’s ability to continue to claim First Amendment 

rights also has been questioned based on the business decisions 

and the roles undertaken by rating agencies over the last decade. 

Rating agencies have abandoned their former practice of rating 

most or all securities whether or not hired to do so, and rating 

agencies have become deeply involved in the structuring of complex 

securities, which are normally not sold to retail investors. These 

changes warrant serious attention when considering whether rating agencies still merit the protection that the First Amendment 

may have provided to them in their more traditional role. 23

In addition to increasing legal accountability for rating agencies, 

we believe that rating agencies would have greater ability to 

produce high quality and more reliable ratings if they were required to conduct better due diligence and verification. Under current SEC rules, it is difficult for a user of a rating to gauge the 

accuracy of the information being analyzed by the rating agency 

and, thus, evaluate the rating agency’s ability to assess the creditworthiness of a structured finance product. 24 Rating agencies are 

required neither to verify the information underlying a structured 

finance product received from an issuer nor to compel issuers to 

perform due diligence or to obtain reports concerning the level of 

due diligence performed by issuers of structured finance products. 

To address these concerns, we recommend that credit rating 

agencies be required to conduct due diligence on the information 

they review to issue ratings. In addition, to raise investor confidence in the quality of ratings and the rating process as a whole, 

the due diligence requirements should apply (as appropriate) to all 

rated debt securities, not only structured finance products. Specifically, we recommend that: 
284 

25See Financial Services Regulatory Reform: Discussion and Recommendations, which is 

available at http://www.ici.org/pdf/pprl09lreglreform.pdf. We note that the white paper 

was included as an attachment to ICI’s written testimony. 

• Rating agencies be required to have policies and procedures in 

place reasonably sufficient to assess the credibility of the information they receive from issuers and underwriters. 

• Rating agencies disclose these policies and procedures, the specific steps taken to verify information about the assets underlying a security, and the results of the verification process. 

• Rating agencies disclose the limitations of the available information or data, any actions they take to compensate for any 

missing information or data, and any risks involved with the 

assumptions and methodologies they use in providing a rating. 

• Rating agencies be required to certify that the rating agency 

has satisfied its stated policies and procedures for performing 

due diligence on the security being rated. 

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds Association testified before the House Subcommittee on Capital Markets 

and said: ‘‘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.’’ MFA supported the creation or designation of a ‘‘single 

central systemic risk regulator’’ that (1) has ‘‘the authority to request and receive, on a confidential basis, from those entities that 

it determines . . . 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,’’ (2) has 

a mandate of protection of the financial system, but not investor 

protection or market integrity and (3) has the authority to ensure 

that a failing market participant does not pose a risk to the entire 

financial system. 

Do you agree with MFA’s position? Do you feel there should be 

regulation of hedge funds along these lines or otherwise? 

A.6. Systemic Risk Regulation: Over the past year, various policymakers and other commentators have called for the establishment 

of a formal mechanism for identifying, monitoring, and managing 

risks to the financial system as a whole. ICI concurs with those 

commentators and with the Managed Funds Association (MFA) 

that creation of such a mechanism is necessary. The ongoing financial crisis has highlighted the vulnerability of our financial system 

to risks that have the potential to spread rapidly throughout the 

system and cause significant damage. A mechanism that will allow 

Federal regulators to look across the system should equip them to 

better anticipate and address such risks. 

Generally speaking, MFA’s statement about a ‘‘single central systemic risk regulator’’ touches on some of the same themes that ICI 

addressed in its March 3, 2009, white paper, Financial Services 

Regulatory Reform: Discussion and Recommendations. 25 In our 

white paper, we endorsed the designation of a new or existing 

agency or inter-agency body as a ‘‘Systemic Risk Regulator.’’ Broadly stated, the goal in establishing a Systemic Risk Regulator should 

be to provide greater overall stability to the financial system as a 

whole. The Systemic Risk Regulator should have responsibility for: 
285 

26See, e.g., Peter J. Wallison, Regulation Without Reason: The Group of Thirty Report, AEI 

Financial Services Outlook (Jan. 2009), available at http://www.aei.org/publications/ 

pubID.29285/publdetail.asp 

(1) monitoring the financial markets broadly; (2) analyzing changing conditions in domestic and overseas markets; (3) evaluating the 

risks of practices as they evolve and identifying those that are of 

such nature and extent that they implicate the health of the financial system at large; and (4) acting to mitigate such risks in coordination with other responsible regulators. 

In ICI’s view, Congress should determine the composition and 

authority of the Systemic Risk Regulator with two important cautions in mind. First, the legislation establishing the Systemic Risk 

Regulator should be crafted to avoid imposing undue constraints or 

inapposite forms of regulation on normally functioning elements of 

the financial system, or stifling innovations, competition or efficiencies. By way of example, it has been suggested that a Systemic 

Risk Regulator could be given the authority to identify financial institutions that are ‘‘systemically significant’’ and to oversee those 

institutions directly. Such an approach could have very serious 

anticompetitive effects if the identified institutions were viewed as 

‘‘too big to fail’’ and thus judged by the marketplace as safer bets 

than their smaller, ‘‘less significant’’ competitors. 26

Second, the Systemic Risk Regulator should not be structured to 

simply add another layer of bureaucracy or to displace the primary 

regulator(s) responsible for capital markets, banking or insurance. 

We strongly concur with MFA that the Systemic Risk Regulator 

should focus principally on protecting the financial system—as discussed in detail in our white paper, we believe that a strong and 

independent Capital Markets Regulator (or, until such agency is established by Congress, the Securities and Exchange Commission) 

should focus principally on the equally important mandates of protecting investors and maintaining market integrity. Legislation establishing the Systemic Risk Regulator should define the nature of 

the relationship between this new regulator and the primary regulator(s) for each industry sector. This should involve carefully defining the extent of the authority granted to the Systemic Risk 

Regulator, as well as identifying circumstances under which the 

Systemic Risk Regulator and primary regulator(s) should coordinate their efforts and work together. We believe, for example, that 

the primary regulators have a critical role to play by acting as the 

first line of defense with regard to detecting potential risks within 

their spheres of expertise. 

In view of the two cautions outlined above, ICI believes that the 

Systemic Risk Regulator would be best structured as a statutory 

council comprised of senior Federal regulators. Membership should 

include, at a minimum, the Secretary of the Treasury, Chairman 

of the Federal Reserve Board of Governors, and the heads of the 

Federal bank and capital markets regulators (and insurance regulator, if one emerges at the Federal level). 

Regulation of the Hedge Fund Industry—Appropriate Focus of 

Regulatory Oversight: In 2004, the Securities and Exchange Commission (SEC) adopted a rule to require hedge fund advisers to register with the SEC as investment advisers. ICI supported this registration requirement as a way to provide the SEC with reliable, 
286 

27See Written Testimony of SEC Chairman Before the U.S. Senate Committee on Banking, 

Housing and Urban Affairs (July 25, 2006) (concerning the regulation of hedge funds), available 

at http://www.sec.gov/news/testimony/2006/ts072506cc.htm 

28 It is imperative, of course, that the Capital Markets Regulator (or SEC) be organized and 

staffed, and have sufficient resources, to effectively perform this oversight function. 

current, and meaningful information about this significant segment 

of the capital markets without adversely impacting the legitimate 

operations of hedge fund advisers. Many ICI member firms—all of 

whom are registered with the SEC—currently operate hedge funds 

and have found that registration is not overly burdensome and 

does not interfere with their investment activities. 

In June 2006, the SEC’s hedge fund adviser registration rule was 

struck down by the U.S. Court of Appeals for the D.C. Circuit. The 

following month, in testimony before this Committee, then SEC 

Chairman Christopher Cox commented that the rule’s invalidation 

had forced the SEC ‘‘back to the drawing board to devise a workable means of acquiring even basic census data that would be necessary to monitor hedge fund activity in a way that could mitigate 

systemic risk.’’ 27

In our white paper, we call for this regulatory gap to be closed. 

Specifically, ICI recommends that the Capital Markets Regulator 

(or SEC) have express regulatory authority to provide oversight 

over hedge funds (through their advisers) with respect to, at a minimum, their potential impact on the capital markets. 28 For example, similar to MFA’s recommendation, we state that the regulator 

could require nonpublic reporting of information such as investment positions and strategies that could bear on systemic risk and 

adversely impact other market participants. 

We continue to believe that hedge fund adviser registration is an 

appropriate response to address the risks that hedge funds can 

pose to the capital markets and other market participants. In this 

regard, the Capital Markets Regulator (or SEC) may wish to consider the adoption of specific rules under the Investment Advisers 

Act of 1940 that are tailored to the specific business practices of, 

and market risks posed by, hedge funds. Areas of focus for such 

rulemaking should include, for example, disclosure regarding valuation practices and the calculation of investment performance; both 

of these areas have been criticized as lacking transparency and 

presenting the potential for abuse. 

ICI does not support, however, requiring the registration of individual hedge funds with the SEC. Rather, as discussed in detail 

below, ICI believes there must continue to be a strict dividing line 

between registered, highly regulated investment companies and unregistered, lightly regulated hedge funds. A registration requirement for hedge funds would blur this line, invariably causing confusion for both investors and the marketplace. This confusion 

would likely exacerbate already imprecise uses of the term ‘‘fund’’ 

to refer to investment pools, whether registered or not. Further, we 

believe it is imperative to keep any problems in the hedge fund 

area from bleeding over in the public’s mind to include mutual 

funds, which are owned by almost half of all U.S. households. 

Maintaining the distinctions between investment companies and 

hedge funds—Compared to registered investment companies, which 

are subject to the comprehensive and rigorous regulatory regime 
287 

29See Non-Public Offering Exemption, SEC Rel. No. 33-4552 (Nov. 6, 1962) at text preceding 

n.2, text preceding n.3 (‘‘Consideration must be given not only to the identity of the actual purchasers but also to the offerees. Negotiations or conversations with or general solicitations of 

an unrestricted and unrelated group of prospective purchasers for the purpose of ascertaining 

who would be willing to accept an offer of securities is inconsistent with a claim that the transaction does not involve a public offering even though ultimately there may only be a few knowledgeable purchasers . . . . Public advertising of the offerings would, of course, be incompatible 

with a claim of a private offering.’’). 30See Privately Offered Investment Companies, SEC Rel. No. IC-22597 (April 3, 1997), at n.5. 

set forth in the Investment Company Act of 1940 and related rules, 

hedge funds are lightly regulated investment products. Hedge 

funds are effectively outside the purview of the Investment Company Act by reason of Sections 3(c)(1) and 3(c)(7), which require 

that the hedge fund is not making or proposing to make a public 

offer of its securities and that those securities be sold only to certain specific groups of investors. These provisions thus place express statutory limits on both the offer and the sale of securities 

issued by a hedge fund. ICI firmly believes that these limits must 

be preserved and should be reconfirmed in any legislation enacted 

to regulate hedge funds or their advisers. 

No general solicitation or public advertising by hedge funds—Despite clear statutory language precluding a hedge fund from ‘‘making or proposing to make a public offer of its securities,’’ there have 

been several occasions in the recent past where the hedge fund industry has argued that it should be able to advertise through the 

public media, while remaining free from the regulatory restrictions 

and shareholder protections imposed by the Investment Company 

Act. Additionally, in 2003, the SEC staff recommended that the 

SEC consider eliminating the prohibition on general solicitation in 

offerings by certain hedge funds. ICI emphatically opposes any 

such efforts, because allowing hedge funds organized pursuant to 

Sections 3(c)(1) and 3(c)(7) to engage in any form of general solicitation or public advertising is fundamentally inconsistent with 

hedge funds’ exclusion from regulation under the Investment Company Act. 

Section 3(c)(7) was added to the Investment Company Act in 

1996, in apparent recognition that the full panoply of investment 

company regulation is not necessary for hedge funds (and other private investment pools) offered and sold only to financially sophisticated investors able to bear the risk of loss associated with their 

investment. The ‘‘no public offering’’ language used by Congress in 

Section 3(c)(7) generally tracks the language in Section 4(2) of the 

Securities Act of 1933. For almost five decades, the SEC has taken 

the position that public advertising is inconsistent with a nonpublic 

offering of securities under Section 4(2). 29

In its rulemaking to implement Section 3(c)(7) and related provisions, the SEC observed that ‘‘while the legislative history . . . 

does not explicitly discuss Section 3(c)(7)’s limitation on public offerings by Section 3(c)(7) funds, the limitation appears to reflect 

Congress’s concerns that unsophisticated individuals not be inadvertently drawn into [such] funds.’’ 30 A member of Congress intimately involved in this debate later concurred with the SEC’s interpretation in a letter to then SEC Chairman Arthur Levitt. His 

letter further explained: 

In 1996, as part of the National Securities Markets Improvement Act, Congress 

reaffirmed that hedge funds should not be publicly marketed, specifically adding 
288 

31See Letter from Rep. Edward J. Markey (D-Mass.) to SEC Chairman Arthur Levitt, dated 

Dec. 18, 2000. 32For a detailed discussion of the Institute’s views on these issues, see Letter from Paul 

Schott Stevens, President and CEO, Investment Company Institute, to Nancy M. Morris, Secretary, U.S. Securities and Exchange Commission, dated Oct. 9, 2007, available at http:// 

www.sec.gov/comments/s7-18-07/s71807-37.pdf 

this restriction to a modernized hedge fund exemption that was included in the 

final bill. As you will recall, I was one of the authors of this provision . . . I 

believe that the Congress has appropriately drawn the lines regarding hedge 

fund marketing, and intend to strongly oppose any effort to liberalize them. 31

Any form of general solicitation or public advertising of unregistered hedge funds would surely cause investors to confuse such 

funds with registered, highly regulated investment companies. It 

also would present greater opportunities for perpetrators of securities fraud to identify and target unsophisticated investors. This potential for investor confusion and fraudulent activity would be compounded by the fact that the SEC simply would not have the resources to monitor advertisements by hedge funds—whether legitimate or fraudulent—in any meaningful way. 

For all of these reasons, ICI firmly believes that there must continue to be a strict prohibition on any form of general solicitation 

or public advertising in connection with hedge fund offerings. 

Limitations on who may invest in hedge funds—No less critical 

is the need to ensure that interests in hedge funds are sold only 

to financially sophisticated investors able to bear the economic risk 

of their investment. To this end, ICI believes that the accredited 

investor standards in Regulation D under the Securities Act of 

1933 (which determine investor eligibility to participate in unregistered securities offerings by hedge funds and other issuers) should 

be immediately adjusted to correct for the substantial erosion in 

those standards since their adoption in 1982. This one-time adjustment should be coupled with periodic future adjustments to keep 

pace with inflation. Specifically, ICI has recommended that the 

SEC’s Office of Economic Analysis be required to reset the accredited investor thresholds every 5 years, so that the percentage of the 

population qualifying as accredited investors would remain stable 

over time. This would entail a straightforward economic analysis 

that could be performed using widely available government databases. 32

Also in this regard, ICI continues to support the SEC’s 2006 proposal to raise the eligibility threshold for individuals wishing to invest in hedge funds (and other private investment pools) organized 

under Section 3(c)(1) of the Investment Company Act. Specifically, 

an individual would need to be an ‘‘accredited investor’’ based upon 

specified net worth or income levels, as is now required, and own 

at least $2.5 million in investments. According to the SEC, this 

new two-step approach would mirror the existing eligibility requirements that Congress determined were appropriate for investors in hedge funds organized under Section 3(c)(7). 

Q.7. Self-Regulatory Organizations: How do you feel the self-regulatory securities organizations have performed during the current 

financial crisis? Are there changes that should be made to the selfregulatory organizations to improve their performance? Do you feel 

there is still validity in maintaining the self-regulatory structure or 

that some powers should be moved to the SEC or elsewhere? 
289 

33See Statement of the Investment Company Institute on the Review of the U.S. Financial 

Markets and Global Markets Competitiveness, Submitted to the Senate Republican Capital Markets Task Force, U.S. Senate (February 25, 2008) and Submission of the Investment Company 

Institute to the Department of the Treasury, Review of the Regulatory Structure Associated 

with Financial Institutions (December 7, 2007). 34See Letters from Craig S. Tyle, General Counsel, Investment Company Institute, to Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission, dated April 6, 2001, and 

Dorothy M. Donohue, Associate Counsel, Investment Company Institute, to Jonathan G. Katz, 

Secretary, U.S. Securities and Exchange Commission, dated June 4, 2004. 35See, e.g., Letter from Ari Burstein, Associate Counsel, Investment Company Institute, to 

Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission, dated March 8, 2005. 36See Regulating Broker-Dealers and Investment Advisers: Demarcation or Harmonization?, 

Speech by SEC Commissioner Elisse B. Walter Before the Mutual Fund Directors Forum Ninth 

Annual Policy Conference (May 5, 2009), available at http://www.sec.gov/news/speech/2009/ 

spch050509ebw.htm 

A.7. Self-regulatory organizations (SROs) form an integral part of 

the current system of securities markets oversight. ICI has had a 

longstanding interest in the effective and efficient operation of 

SROs, and we support an examination of their role and operations. 

We believe there may be several ways to improve SROs’ performance and operations, particularly through enhancements to their 

rules and rulemaking processes, and their governance structure. 

SRO rules should be crafted both to protect investors and to promote efficiency, competition and capital formation. To achieve these 

objectives, it is critically important that SROs consider the relative 

costs and benefits of their rules. We have recommended on several 

occasions that Congress by law, or the SEC by rule, require that 

all SROs evaluate the costs and benefits of their rule proposals 

prior to submission to the SEC and establish a process for reexamining certain existing rules. 33 This process should be designed to 

determine whether the rules are working as intended, whether 

there are satisfactory alternatives of a less burdensome nature, and 

whether changes should be made. 

The SRO rulemaking process itself serves important policy goals, 

including, among other things, assuring that interested persons 

have an opportunity to provide input regarding SRO actions that 

could have a significant effect on the market and market participants. ICI has supported amendments that would improve the ability of interested persons to submit comments on SRO actions. In 

particular, we have recommended extending the length of the comment period for any significant SRO proposal. 34

Finally, ICI supports efforts to strengthen SRO governance processes. 35 For example, to ensure that the views of investors are adequately represented, we have recommended that SROs be required 

to have sufficient representation from funds and other institutional 

investors in their governance structures. In addition, to address 

concerns that SROs are inherently subject to conflicts of interest, 

consideration should be given to requiring SRO boards to have an 

appropriate balance between public members and members with 

industry expertise. 36

Q.8. Structure of the SEC: Please share your views as to whether 

you feel that the current responsibilities and structure of the SEC 

should be changed. 

Please comment on the following specific proposals: 

1. Giving some of the SEC’s duties to a systemic risk regulator 

or to a financial services consumer protection agency; 
290 

37See Financial Services Regulatory Reform: Discussion and Recommendations, which is 

available at http://www.ici.org/pdf/pprl09lreglreform.pdf. We note that the white paper 

was included as an attachment to ICI’s written testimony. 

2. Combining the SEC into a larger ‘‘prudential’’ financial services regulator; 

3. Adding another Federal regulators’ or self-regulatory organizations’ powers or duties to the SEC. 

A.8. Investment companies (funds) are both major holders of securities issued by public companies and issuers of securities (fund 

shares) held by almost half of all U.S. households. As such, they 

have a vested interest in the effective regulation of the capital markets by a strong and independent regulator. Funds and their shareholders stand to benefit if that regulator has the tools it needs to 

fulfill important policy objectives, such as: preserving the integrity 

of the capital markets; ensuring the adequacy and accuracy of periodic disclosures by public issuers; and promoting fund regulation 

that protects investors, encourages innovation, and does not hinder 

market competition. 

As discussed in its March 3, 2009, white paper, Financial Services Regulatory Reform: Discussion and Recommendations, 37 ICI 

supports the creation of a new Capital Markets Regulator that 

would encompass the combined functions of the Securities and Exchange Commission (SEC) and those of the Commodity Futures 

Trading Commission (CFTC) that are not agriculture-related. In 

our response below to part A of the question, we briefly discuss this 

recommendation and our suggestions relating to the Capital Markets Regulator’s responsibilities and structure. Pending, or in the 

absence of, Congressional action to create a Capital Markets Regulator, most of our recommendations just as appropriately could be 

applied to the SEC. Where appropriate for ease of discussion, we 

use the term ‘‘agency’’ to refer equally to the SEC or a new Capital 

Markets Regulator. 

We then address the issues outlined in part B of the question in 

the context of a discussion about how the SEC or a new Capital 

Markets Regulator should fit within the broader financial services 

regulatory framework. 

Reforming the Responsibilities and Structure of the SEC: To 

bring a consistent policy focus to U.S. capital markets, ICI strongly 

recommends the creation of a new Capital Markets Regulator. Currently, securities and futures are subject to separate regulatory regimes under different Federal regulators. This system reflects historical circumstances that have changed significantly. As recently 

as the mid-1970s, for example, agricultural products accounted for 

most of the total U.S. futures exchange trading volume. By the late 

1980s, a shift from the predominance of agricultural products to financial instruments and currencies was readily apparent in the 

volume of trading on U.S. futures exchanges. In addition, as new, 

innovative financial instruments were developed, the lines between 

securities and futures often became blurred. The existing, divided 

regulatory approach has resulted in jurisdictional disputes between 

the SEC and the CFTC, regulatory inefficiency, and gaps in investor protection and market oversight. With the increasing conver-
291 

38 Currently, regulatory oversight of both the securities and futures industries involves various self-regulatory organizations. In establishing a Capital Markets Regulator, Congress would 

need to determine the appropriate role for any such organization(s). 

gence of securities and futures products, markets, and market participants, the current system simply makes no sense. 

As envisioned by ICI, the Capital Markets Regulator would be a 

single, independent Federal regulator responsible for oversight of 

U.S. capital markets, market participants, and all financial investment products. It would have an express statutory mission and the 

rulemaking and enforcement powers necessary to carry out that 

mission. 38 From the perspective of the fund industry, the mission 

of the Capital Markets Regulator must involve maintaining a sharp 

focus on investor protection, supported by a comprehensive enforcement program. This core feature of the SEC’s mission has consistently distinguished the SEC from the banking regulators, who are 

principally concerned with the safety and soundness of the financial institutions they regulate, and it has generally served investors 

well over the years. 

Examination of the recent financial crisis has prompted calls for 

Congress to close regulatory gaps to ensure appropriate oversight 

of all market participants and investment products. In our white 

paper, we recommend that the Capital Markets Regulator (or SEC) 

have express regulatory authority to provide oversight with regard 

to hedge funds, derivatives, and municipal securities. We further 

recommend that the agency be given explicit authority to harmonize the legal standards applicable to investment advisers and 

broker-dealers. 

How a regulatory agency is managed, and the details of its organizational structure, can have significant implications for the agency’s effectiveness. In our white paper, we offer the following suggestions with regard to management and organization of the Capital 

Markets Regulator (or SEC). 

• Ensure high-level focus on agency management. One approach 

would be to designate a Chief Operating Officer for this purpose. 

• Implement a comprehensive process for setting regulatory priorities and assessing progress. It may be helpful to draw upon 

the experience of the United Kingdom’s Financial Services Authority, which seeks to follow a methodical approach that includes developing a detailed annual business plan establishing 

agency priorities and then reporting annually the agency’s 

progress in meeting prescribed benchmarks. 

• Promote open and effective lines of communication among the 

Commissioners and between the Commissioners and staff. 

Such communication is critical to fostering awareness of issues 

and problems as they arise, thus increasing the likelihood that 

the agency will be able to act promptly and effectively. A range 

of approaches may be appropriate to consider in meeting this 

goal, including whether sufficient flexibility is provided under 

the Government in the Sunshine Act, and whether the number 

of Commissioners should be greater than the current number 

at the SEC (five). 
292 

• Align the inspections and examinations functions and the policymaking divisions. This approach would have the benefit of 

keeping staff in the policymaking divisions updated on current 

market and industry developments, as well as precluding any 

de facto rulemaking by the agency’s inspections staff. 

• Develop mechanisms to facilitate coordination and information 

sharing among the policymaking divisions. These mechanisms 

would help to ensure that the agency speaks with one voice. 

How the SEC (or a New Capital Markets Regulator) Fits Within 

the Broader Financial Services Regulatory Framework: Today’s financial crisis has demonstrated that the current system for oversight of U.S. financial institutions is insufficient to address modern 

financial markets. In its white paper, ICI recommends changes to 

create a regulatory framework that enhances regulatory efficiency, 

limits duplication, closes regulatory gaps, and emphasizes the national character of the financial services industry. In brief, ICI supports: 

• Creating a consolidated Capital Markets Regulator, as discussed above; 

• Establishing a ‘‘Systemic Risk Regulator’’ that would identify, 

monitor and manage risks to the financial system as a whole; 

• Considering consolidation of the regulatory structure for the 

banking sector; 

• Authorizing an optional Federal charter for insurance companies; and 

• Promoting effective coordination and information sharing 

among the various financial regulators, including in particular 

the new Systemic Risk Regulator. 

Increased consolidation of financial services regulators, combined 

with the establishment of a Systemic Risk Regulator and more robust inter-agency coordination and information sharing, should facilitate monitoring and mitigation of risks across the financial system. We believe that consolidation of regulatory agencies also may 

further the competitive posture of the U.S. financial markets and 

could make it easier, when appropriate, to harmonize U.S. regulations with regulations in other jurisdictions. Reducing the number 

of U.S. regulatory agencies, while also strengthening the culture of 

cooperation and dialogue among senior officials of the agencies, will 

likely facilitate coordinated interaction with regulators around the 

world. 

By providing for one or more dedicated regulators to oversee each 

major financial services sector, this proposed structure would maintain the specialized focus and expertise that is a hallmark of effective regulation. This structure also would allow appropriate tailoring of regulation to accommodate fundamental differences in regulated entities, products and activities. Additionally, it would avoid 

the potential for one industry sector to take precedence over the 

others in terms of regulatory priorities or approaches or the allocation of regulatory resources. 

In particular, the regulatory structure favored by ICI would preserve the important distinctions between the mission of the Capital 

Markets Regulator (or SEC), which is sharply focused on investor 
293 

protection, and that of the banking regulators, which is principally 

concerned with the safety and soundness of the banking system. 

Both regulatory approaches have a critical role to play in ensuring 

a successful and vibrant financial system, but neither should be allowed to trump the other. For this reason, we believe it would be 

inappropriate to combine the SEC into a larger ‘‘prudential’’ financial services regulator, a move that could result in diminished investor protections. 

Preserving regulatory balance, and bringing to bear different perspectives, is a theme that has influenced ICI’s thinking on how to 

structure a Systemic Risk Regulator. In our white paper, we suggested that very careful consideration must be given to the specifics 

of how a Systemic Risk Regulator would be authorized to perform 

its functions. We offered two important cautions in that regard. 

First, we recommended that the legislation establishing the Systemic Risk Regulator should be crafted to avoid imposing undue 

constraints or inapposite forms of regulation on normally functioning elements of the financial system, or stifling innovations, 

competition or efficiencies. Second, we recommended that the Systemic Risk Regulator should not be structured to simply add another layer of bureaucracy or to displace the primary regulator(s) 

responsible for capital markets, banking, or insurance. 

Legislation establishing the Systemic Risk Regulator thus should 

define the nature of the relationship between this new regulator 

and the primary regulator(s) for each industry sector. This should 

involve carefully defining the extent of the authority granted to the 

Systemic Risk Regulator, as well as identifying circumstances 

under which the Systemic Risk Regulator and primary regulator(s) 

should coordinate their efforts and work together. We believe, for 

example, that the primary regulators have a critical role to play by 

acting as the first line of defense with regard to detecting potential 

risks within their spheres of expertise. 

In view of the two cautions outlined above, ICI believes that the 

Systemic Risk Regulator would be best structured as a statutory 

council comprised of senior Federal regulators. Membership should 

include, at a minimum, the Secretary of the Treasury, Chairman 

of the Federal Reserve Board of Governors, and the heads of the 

Federal bank and capital markets regulators (and insurance regulator, if one emerges at the Federal level). 

Finally, we note that the question requests comment on whether 

some of the SEC’s duties should be given to a financial services 

consumer protection agency. As a general matter, we observe that 

Federal regulators must improve their ability to keep up with new 

market developments. This will require both nimbleness at the regulatory level and Congressional willingness to close regulatory 

gaps, provide new authority where appropriate, and even provide 

additional resources. ICI does not believe, however, that it would 

be helpful to create a new ‘‘financial products safety commission’’ 

or ‘‘financial services consumer protection agency.’’ Financial products and services arise and exist in the context of a larger marketplace, and they need to be understood in that context. The primary 

regulator is best positioned to perform this function. 

Q.9. SEC Staffing, Funding, and Management: The SEC has a 

staff of about 3,500 full-time employees and a budget of $900 mil-
294 

39See Financial Services Regulatory Reform: Discussion and Recommendations, which is 

available at http://www.ici.org/pdf/pprl09lreglreform.pdf. We note that the white paper 

was included as an attachment to ICI’s written testimony. 40See Testimony of Elisse B. Walter, Commissioner, U.S. Securities and Exchange Commission, Before the House Committee on Financial Services, Concerning Securities Law Enforcement in the Current Financial Crisis (March 20, 2009) at 30-31. 

lion. It has regulatory responsibilities with respect to approximately: 12,000 public companies whose securities are registered 

with it; 11,300 investment advisers; 950 mutual fund complexes; 

5,500 broker-dealers (including 173,000 branch offices and 665,000 

registered representatives); 600 transfer agents, 11 exchanges; 5 

clearing agencies; 10 nationally recognized statistical rating organizations; SROs such as the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board and the Public 

Company Accounting Oversight Board. 

To perform its mission effectively, do you feel that the SEC is appropriately staffed? funded? managed? How would you suggest that 

the Congress could improve the effectiveness of the SEC? 

A.9. Investment companies (funds) are both major holders of securities issued by public companies and issuers of securities (fund 

shares) that are held by almost half of all U.S. households. As 

such, they have a vested interest in effective regulation of the capital markets by a strong and independent regulator. Funds, and 

therefore their shareholders, stand to benefit if that regulator has 

the tools it needs to fulfill important policy objectives, such as: preserving the integrity of the capital markets; ensuring the adequacy 

and accuracy of periodic disclosures by public issuers; and promoting fund regulation that protects our investors, encourages innovation, and does not hinder market competition. 

As discussed in our March 3, 2009, white paper, Financial Services Regulatory Reform: Discussion and Recommendations, 39 ICI 

supports the creation of a new Capital Markets Regulator that 

would encompass the combined functions of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading 

Commission (CFTC). The white paper makes a series of recommendations—including several concerning the staffing, funding, 

and management of the Capital Markets Regulator—aimed at 

maximizing this regulator’s ability to perform its mission effectively. Pending, or in the absence of, Congressional action to create 

a Capital Markets Regulator, most of our recommendations just as 

appropriately could be applied to the SEC. An outline of those recommendations is included in the response below. Where appropriate for ease of discussion, we use the term ‘‘agency’’ to refer 

equally to the SEC or a new Capital Markets Regulator. 

Agency Funding, and Staffing: ICI consistently has called for 

adequate funding for the SEC in order to support its critical regulatory functions. We note that, in testimony before the House Financial Services Committee in March of this year, SEC Commissioner Elisse Walter stated that the SEC’s examination and enforcement resources are inadequate to keep pace with the growth 

and innovation in the securities markets. 40 We believe that Congress must seriously consider any suggestion from senior SEC officials that additional resources are required. We were pleased, 

therefore, to hear about the recent bipartisan effort, led by Sen-
295 

41See SEC Announces New Initiative to Identify and Assess Risks in Financial Markets 

(April 30, 2009), available at http://www.sec.gov/news/press/2009/2009-98.htm 

ators Charles Schumer (D-NY) and Richard Shelby (R-AL) and endorsed by SEC Chairman Mary Schapiro, to increase the SEC’s 

budget by $20 million for fiscal years 2010 and 2011 in order to 

add enforcement staff and fund needed technology upgrades. 

ICI believes that the agency also must have greater ability (and 

resources) to attract and retain professional staff having significant 

prior industry experience. Their practical perspectives would enhance the agency’s ability to keep current with market and industry developments and better understand the impact of such developments on regulatory policy. The SEC’s announcement of a new 

Industry and Market Fellows Program is an encouraging step in 

the right direction. 41 As discussed further below, the agency also 

should build strong economic research and analytical capabilities 

and should consider having economists resident in each division. 

Examination of the recent financial crisis has prompted calls for 

Congress to close regulatory gaps to ensure appropriate oversight 

of all market participants and investment products. In our white 

paper, we recommend that the Capital Markets Regulator (or SEC) 

have express regulatory authority to provide oversight with regard 

to hedge funds, derivatives, and municipal securities. To the extent 

that the scope of the agency’s responsibilities is expanded, it will 

be imperative that it have sufficient staffing and resources to effectively perform all of its oversight functions. 

Agency Management and Organization: How a regulatory agency 

is managed, and the details of its organizational structure, can 

have significant implications for the agency’s effectiveness. In our 

white paper, we offer the following suggestions with regard to 

agency management and organization. 

• Ensure high-level focus on agency management. One approach 

would be to designate a Chief Operating Officer for this purpose. 

• Implement a comprehensive process for setting regulatory priorities and assessing progress. It may be helpful to draw upon 

the experience of the United Kingdom’s Financial Services Authority, which seeks to follow a methodical approach that includes developing a detailed annual business plan establishing 

agency priorities and then reporting annually the agency’s 

progress in meeting prescribed benchmarks. 

• Promote open and effective lines of communication among the 

Commissioners and between the Commissioners and staff. 

Such communication is critical to fostering awareness of issues 

and problems as they arise, thus increasing the likelihood that 

the agency will be able to act promptly and effectively. A range 

of approaches may be appropriate to consider in meeting this 

goal, including whether sufficient flexibility is provided under 

the Government in the Sunshine Act, and whether the number 

of Commissioners should be greater than the current number 

at the SEC (five). 

• Align the inspections and examinations functions and the policymaking divisions. This approach would have the benefit of 
296 

keeping staff in the policymaking divisions updated on current 

market and industry developments, as well as precluding any 

de facto rulemaking by the agency’s inspections staff. 

• Develop mechanisms to facilitate coordination and information 

sharing among the policymaking divisions. These mechanisms 

would help to ensure that the agency speaks with one voice. 

Improving Agency Effectiveness: Our white paper recommends 

the following additional ways to enhance the agency’s ability to fulfill its mission successfully when carrying out its regulatory responsibilities: 

1. Establish the conditions necessary for constructive, ongoing 

dialogue with the regulated industry: The agency should seek 

to facilitate closer, cooperative interaction with the entities it 

regulates to identify and resolve problems, to determine the 

impact of problems or practices on investors and the market, 

and to cooperatively develop best practices that can be shared 

broadly with market participants. Incorporating a more preventative approach would likely encourage firms to step forward with self-identified problems and proposed resolutions. 

The net result is that the agency would pursue its investor 

protection responsibilities through various means not always 

involving enforcement measures, although strong enforcement 

must remain an important weapon in the agency’s arsenal. 

2. Establish mechanisms to stay abreast of market and industry 

developments: The agency would benefit from the establishment of one or more external mechanisms designed to help it 

stay abreast of market and industry issues and developments, 

including developments and practices in non-U.S. jurisdictions 

as appropriate. For example, several Federal agencies—including both the SEC and CFTC—utilize a range of advisory 

committees. Such committees, which generally have significant private sector representation, may be established to provide recommendations on a discrete set of issues facing the 

agency (e.g., the SEC’s Advisory Committee on Improvements 

to Financial Reporting) or to provide regular information and 

guidance to the agency (e.g., the CFTC’s Agricultural Advisory 

Committee). 

ICI believes that a multidisciplinary ‘‘Capital Markets Advisory Committee’’ could be a very effective mechanism for providing the agency with ‘‘real world’’ perspectives and insights 

on an ongoing basis. We recommend that such a committee be 

comprised primarily of private sector representatives from all 

major sectors of the capital markets, and include one or more 

members representing funds and asset managers. Additionally, the Capital Markets Advisory Committee should be specifically established in, and required by, legislation. Such a 

statutory mandate would emphasize the importance of this advisory committee to the agency’s successful fulfillment of its 

mission. 

The establishment of an advisory committee would complement other efforts by the agency to monitor developments 

affecting the capital markets and market participants. These 
297 

42The SEC has scheduled an open meeting on May 14, 2009, at which it will consider proposed rule amendments designed to enhance the protections provided to advisory clients when 

they entrust their funds and securities to an investment adviser. The SEC’s meeting announcement indicates that if adopted, the amendments would require investment advisers having custody of client funds and securities to obtain a surprise examination by an independent public 

accountant, and, unless the client assets are maintained with an independent custodian, obtain 

a review of custodial controls from an independent public accountant. See SEC News Digest 

(May 7, 2009), available at http://www.sec.gov/news/digest/2009/dig050709.htm 

efforts should include, first and foremost, hiring more staff 

members with significant prior industry experience. As indicated above, their practical perspectives would enhance the 

agency’s ability to keep current with market and industry developments and better understand the impact of such developments on regulatory policy. 

3. Apply reasonably comparable regulation to like products and 

services: Different investment products often are subject to different regulatory requirements, often with good reason. At 

times, however, heavier regulatory burdens have been placed 

on some investment products or services than on others, even 

where they share similar features and are sold to the same 

customer base. It does not serve investors well if the regulatory requirements placed on funds—which serve over 93 

million investors—end up discouraging investment advisers 

from entering or remaining in the fund business, dissuading 

portfolio managers from managing funds as opposed to other 

investment products, or creating disincentives for brokers and 

other intermediaries to sell fund shares. It is critically important for the agency to be sensitive to this dynamic in its 

rulemakings. 

Among other things, in analyzing potential new regulatory requirements for funds or in other situations as appropriate, the 

agency should consider whether other investment products 

raise similar policy concerns and thus should be subject to 

comparable requirements. In this regard, we note that separately managed accounts sometimes are operated much like 

mutual funds and other investment companies and yet do not 

offer the same level of investor protection. For example, as the 

fallout from the Ponzi scheme perpetrated by Bernard Madoff 

has highlighted, separately managed accounts are not subject 

to all of the restrictions on custody arrangements that serve 

to protect fund assets, and existing rules leave room for 

abuse. 42

4. Develop strong capability to conduct economic analysis to support sound rulemaking and oversight: The agency will be best 

positioned to accomplish its mission if it conducts economic 

analysis in various aspects of the agency’s work, including 

rulemaking, examinations, and enforcement. Building strong 

economic research and analytical capabilities is an important 

way to enhance the mix of disciplines that will inform the 

agency’s activities. From helping the agency look at broad 

trends that shed light on how markets or individual firms are 

operating to enabling it to demonstrate that specific policy initiatives are well-grounded, developing the agency’s capability 

to conduct economic analysis will be well worth the long-term 

effort required. The agency should consider having economists 
298 

43See, e.g., Special Report on Regulatory Reform, Congressional Oversight Panel (submitted 

under Section 125(b)(2) of Title I of the Emergency Economic Stabilization Act of 2008) (Jan. 

2009) (‘‘In tailoring regulatory responses . . . the goal should always be to strike a reasonable 

balance between the costs of regulation and its benefits. Just as speed limits are more stringent 

on busy city streets than on open highways, financial regulation should be strictest where the 

threats-especially the threats to other citizens—are greatest, and it should be more moderate 

elsewhere.’’). 

resident in each division to bring additional, important perspectives to bear on regulatory challenges. 

It is important that economic analysis play an integral role in 

the rulemaking process, because many regulatory costs ultimately are borne by investors. When new regulations are required, or existing regulations are amended, the agency should 

thoroughly examine all possible options and choose the alternative that reflects the best trade-off between costs to, and 

benefits for, investors. Effective cost benefit analysis does not 

mean compromising protections for investors or the capital 

markets. Rather, it challenges the regulator to consider alternative proposals and think creatively to achieve appropriate 

protections while minimizing regulatory burdens, or to demonstrate that a proposal’s costs and burdens are justified in 

light of the nature and extent of the benefits that will be 

achieved. 43

5. Modernize regulations that no longer reflect current market 

structures and practices: Financial markets and related services are constantly evolving, frequently at a pace that can 

make the regulations governing them (or the rationale behind 

those regulations) become less than optimal, if not entirely obsolete. Requiring industry participants to comply with outmoded regulations imposes unnecessary costs on both firms 

and investors, may impede innovation, and, most troubling of 

all, could result in inadequate protection of investors. It is 

thus important that the agency engage in periodic reviews of 

its existing regulations to determine whether any such regulations should be modernized or eliminated. 

6. Give heightened attention to investor education: The recent 

turmoil in the financial markets has underscored how important it is that investors be knowledgeable and understand 

their investments. Well-informed investors are more likely to 

develop realistic expectations, take a long-term perspective, 

and understand the trade-off between risk and reward. They 

are less likely to panic and make mistakes. 

To better equip investors to make good decisions about their 

investments, the agency should assign a high priority to pursuing regulatory initiatives that will help educate investors. 

The SEC has an Office of Investor Education and Advocacy 

and provides some investor education resources on its Web 

site. These types of efforts should be expanded, possibly in 

partnership with other governmental or private entities, and 

better publicized. Many industry participants, too, have developed materials and other tools to help educate investors; additional investor outreach efforts should be encouraged. 

Q.10. Systemic Risk Regulatory Structure: You have put forth the 

idea of a systemic risk regulator that is organized as a committee 
299 

of financial regulatory heads. Could you please elaborate on the 

structure and organization of such a systemic risk regulatory you 

are suggesting? Also, please describe the positives and negatives of 

such an arrangement and the reasons why it would be superior to 

other possibilities. 

A.10. In light of the financial crisis, it is imperative that Congress 

establish in statute responsibility to address risks to the financial 

system at large. For certain specific and identifiable purposes, such 

as assuring effective consolidated global supervision of the largest 

bank holding companies and overseeing the robust functioning of 

the payment and settlement system as appropriate, this systemic 

risk management responsibility might be lodged with the Federal 

Reserve Board. Beyond this context, however, I recommend that 

systemic risk management responsibility should be assigned to a 

statutory council comprised of senior Federal regulators. 

In concept, such a council would be similar to the National Security Council (NSC), which was established by the National Security 

Act of 1947. In the aftermath of World War II, Congress recognized 

the need to assure better coordination and integration of ‘‘domestic, 

foreign, and military policies relating to the national security’’ and 

the ongoing assessment of ‘‘policies, objectives, and risks.’’ The 

1947 Act established the NSC under the President as a Cabinetlevel council with a dedicated staff. In succeeding years, the NSC 

has proved to be a key mechanism utilized by Presidents to address 

the increasingly complex and multi-faceted challenges of national 

security policy. It was my honor from 1987–89 to serve as statutory 

head (i.e., Executive Secretary) of the NSC. 

As with national security, addressing risks to the financial system at large requires, in my view, diverse inputs and perspectives. 

Membership of such a council accordingly should draw upon a 

broad base of expertise, and should include at a minimum the Secretary of the Treasury, Chairman of the Board of Governors of the 

Federal Reserve System, and the heads of the Federal bank and 

capital markets regulators (and insurance regulator, if one emerges 

at the Federal level). As with the NSC, flexibility should exist to 

enlist other regulators into the work of the council on specific 

issues as required—including, for example, State insurance regulators and self-regulatory organizations. 

By statute, the council should have a mandate to monitor conditions and developments in the domestic and international financial 

markets, to assess their implications for the health of the financial 

system at large, to identify regulatory actions to be taken to address systemic risks as they emerge, to assess the effectiveness of 

these actions, and to advise the President and the Congress on 

emerging risks and necessary legislative or regulatory responses. 

The council would be responsible for coordinating and integrating 

the national response to systemic financial risks, but it would not 

have a direct operating role (much as the NSC coordinates and integrates military and foreign policy that is implemented by the Defense or State Department and not by the NSC itself). Rather, responsibility for addressing identified risks would lie with the existing functional regulators, who would act pursuant to their normal 

statutory authorities but under the council’s direction. 
300 

The Secretary of the Treasury, as the senior-most member of the 

council, should be designated chairman. An executive director, appointed by the President, should run the day-to-day operations of 

the council and serve as head of the council’s staff. The council 

should meet on a regular basis, with an interagency process coordinated through the council’s staff to support and follow through on 

its ongoing deliberations. 

To accomplish its mission, the council should have the support of 

a dedicated, highly-experienced staff. The staff should represent a 

mix of disciplines (e.g., economics, finance and law) and should consist of individuals seconded from government departments and 

agencies (Federal and state), as well as recruited from the private 

sector with a business, professional or academic background. As 

with the NSC, the staff’s focus would be to support the work of the 

council as such, and thus the staff would operate independently 

from the functional regulators. Nonetheless, the background and 

experience of the staff would help assure the kind of strong working relationships with the functional regulators necessary for the 

council’s success. Such a staff could be recruited and at work in a 

relatively short period of time. The focus in recruiting such a staff 

should be on quality, not quantity, and the council’s staff accordingly should not and need not be large. 

Such a council structure has many advantages to recommend it: 

• Systemic risks may arise in different ways and affect different 

parts of the domestic and global financial system. No existing 

agency or department has a comprehensive frame of reference 

or the necessary expertise to assess and respond to any and all 

such risks. Creating such an all-purpose systemic risk manager 

would be a long and complex undertaking, and would involve 

developing expertise that duplicates that which exists in today’s functional regulators. The council structure by contrast 

would enlist the expertise of the entire regulatory community 

in identifying and devising strategies to mitigate systemic 

risks. It also could be established and begin operation much 

more quickly. 

• The council structure would avoid risks inherent in the leading 

alternative that has been proposed—i.e., designating an existing agency like the Federal Reserve Board to serve as an allpurpose systemic risk regulator. In this role, the Federal Reserve understandably may tend to view risks and risk mitigation through its lens as a bank regulator focused on prudential 

regulation and ‘‘safety and soundness’’ concerns, potentially to 

the detriment of consumer and investor protection concerns 

and of non-bank financial institutions. In my view, a council 

such as I have outlined would bring all these competing perspectives to bear and, as a result, would seem far more likely 

to strike the proper balance. 

• Such a council would provide a high degree of flexibility in convening those Federal and State regulators whose input and 

participation is necessary to addressing a specific issue, without creating an unwieldy or bureaucratic structure. As is the 

case with the NSC, the council should have a core membership 
301 

of senior Federal officials and the ability to expand its participants on an ad hoc basis when a given issue so requires. 

• With an independent staff dedicated solely to pursuing the 

council’s agenda, the council would be well positioned to test 

or challenge the policy judgments or priorities of various functional regulators. Moreover, by virtue of their participation on 

the council, the various functional regulators are themselves 

likely to be more attentive to emerging risks or regulatory 

gaps. This would help assure a far more coordinated and integrated approach. Over time, the council also would assist in 

identifying and promoting political consensus about significant 

regulatory gaps and necessary policy responses. 

• The council model anticipates that functional regulators, as 

distinct from the council itself, would be charged with implementing regulations to mitigate systemic risks as they emerge. 

This operational role is appropriate because the functional regulators will have the greatest in depth knowledge of their respective regulated industries. Nonetheless, the council and its 

staff will have an important independent role in evaluating the 

effectiveness of the measures taken by functional regulators to 

mitigate systemic risk and, where necessary, in prompting further actions. 

• A potential criticism of the council structure is that it may diffuse responsibility and pose difficulties in assuring proper follow-through by the functional regulators. I agree it is important that the council have ‘‘teeth,’’ and this can be accomplished, in crafting the legislation, through appropriate amendments to the organic statutes governing the functional regulators. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM PAUL SCHOTT STEVENS 

Q.1. Do you all agree with Federal Reserve Board Chairman 

Bernanke’s remarks today about the four key elements that should 

guide regulatory reform? 

First, we must address the problem of financial institutions that are deemed too 

big—or perhaps too interconnected—to fail. Second, we must strengthen what 

I will call the financial infrastructure—the systems, rules, and conventions that 

govern trading, payment, clearing, and settlement in financial markets—to ensure that it will perform well under stress. Third, we should review regulatory 

policies and accounting rules to ensure that they do not induce excessive 

procyclicality—that is, do not overly magnify the ups and downs in the financial 

system and the economy. Finally, we should consider whether the creation of 

an authority specifically charged with monitoring and addressing systemic risks 

would help protect the system from financial crises like the one we are currently experiencing. 

A.1. In his March 10 speech to the Council on Foreign Relations, 

Chairman Bernanke suggested that policymakers should begin to 

think about ‘‘reforms to the financial architecture, broadly conceived, that could help prevent a similar [financial] crisis from developing in the future.’’ He further highlighted the need for ‘‘a 

strategy that regulates the financial system as a whole, in a holistic way.’’ ICI concurs with Chairman Bernanke that the four areas 

outlined in the question, and discussed in turn below, are key ele-
302 

1See Financial Services Regulatory Reform: Discussion and Recommendations, which is available at http://www.ici.org/pdf/pprl09lreglreform.pdf. We note that the white paper was included as an attachment to ICI’s written testimony. 

ments of such a strategy. It bears emphasizing that this list is not 

exclusive (and that Chairman Bernanke himself did not suggest 

otherwise). In ICI’s view, other key elements of a reform strategy 

include consolidating and strengthening the primary regulators for 

each financial sector, and ensuring more effective coordination and 

information sharing among those regulators. These issues are addressed in detail in ICI’s March 3, 2009, white paper, Financial 

Services Regulatory Reform: Discussion and Recommendations. 1

‘‘Too big to fail’’: ICI agrees that the notion of financial institutions that are too big or too interconnected to fail deserves careful 

attention. The financial crisis has highlighted how the activities of 

large financial institutions can have wide-ranging effects on the 

economy. It is incumbent upon policymakers and other interested 

parties to consider how best to mitigate the risks that the activities 

of large financial institutions can pose to the financial system as 

a whole. 

As part of this analysis, one issue is how to define what is meant 

by ‘‘too big to fail.’’ If it means that certain large financial institutions will receive either explicit or implicit Federal guarantees of 

their debt, such institutions will gain an unfair competitive advantage. Allowing these institutions to borrow at risk-free (or near 

risk-free) interest rates could encourage them to take excessive 

risks, and may cause them to grow faster than their competitors, 

both of which potentially would magnify systemic risks. Ultimately, 

U.S. taxpayers would bear the costs of such actions. 

Chairman Bernanke echoed these concerns in his March 10 remarks. He described the undesirable effects if market participants 

believe that a firm is considered too big to fail, indicating that this 

belief: 

reduces market discipline and encourages excessive risk-taking by the firm. It 

also provides an artificial incentive for firms to grow, in order to be perceived 

as too big to fail. And it creates an unlevel playing field with smaller firms, 

which may not be regarded as having implicit government support. Moreover, 

government rescues of too-big-to-fail firms can be costly to taxpayers, as we 

have seen recently. 

Legislative or regulatory reforms aimed at addressing risks to 

the financial system posed by the activities of large and complex 

financial firms must be designed to avoid these results. 

Strengthening the Financial Infrastructure: ICI strongly concurs 

with Chairman Bernanke’s comments about the need to strengthen 

the financial infrastructure, in order to improve the ability of the 

financial system to withstand future shocks and ‘‘reduc[e] the 

range of circumstances in which systemic stability concerns might 

prompt government intervention.’’ For example, we support current 

initiatives toward centralized clearing for credit default swaps 

(CDS). Central clearing should help reduce counterparty risk and 

bring transparency to trading in the types of CDS that can be 

standardized. Not all CDS are sufficiently standardized to be centrally cleared, however, and institutional investors will continue to 

need to conduct over-the-counter transactions in CDS. For those 

transactions, we support reasonable reporting requirements, in 
303 

2See Report of the Money Market Working Group, Investment Company Institute (March 17, 

2009), available at http://www.ici.org/pdf/pprl09lmmwg.pdf 

order to ensure that regulators have enough data on the CDS market to provide effective oversight. In addition, we would be generally supportive of efforts to improve the market for repurchase 

agreements. Steps such as those we have outlined may serve to 

deepen the relevant markets, encourage buyers and sellers to continue to transact during times of market turmoil and, in particular, 

help foster greater price transparency. 

We further concur with Chairman Bernanke’s assessment of the 

importance of money market funds—particularly their ‘‘crucial 

role’’ in the commercial paper market and as a funding source for 

businesses—and his call for policymakers to consider ‘‘how to increase the resiliency of those funds that are susceptible to runs.’’ 

Similarly, Treasury Secretary Geithner has outlined the Administration’s position on systemic risk and called for action in six areas, 

including the adoption of new requirements for money market 

funds to reduce the risk of rapid withdrawals. In this regard, ICI 

and its members, working through our Money Market Working 

Group, recently issued a comprehensive report outlining a range of 

measures to strengthen money market funds and help them withstand difficult market conditions in the future. 2 More specifically, 

the Working Group’s recommendations are designed to strengthen 

and preserve the unique attributes of a money market fund as a 

low-cost, efficient cash management tool that provides a high degree of liquidity, stability in principal value, and a market-based 

yield. The proposed standards and regulations would ensure that 

money market funds are better positioned to sustain prolonged and 

extreme redemption pressures and that mechanisms are in place to 

ensure that all shareholders are treated fairly if a fund sees its net 

asset value fall below $1.00. 

Secretary Geithner specifically identified the SEC as the agency 

to implement any new requirements for money market funds. ICI 

wholeheartedly concurs that the SEC, as the primary regulator for 

money market funds, is uniquely qualified to evaluate and implement potential changes to the existing scheme of money market 

fund regulation. SEC Chairman Shapiro and members of her staff 

have indicated on several occasions that her agency is currently 

conducting such a review on an expedited basis, and we are pleased 

that the review will include consideration of the Working Group’s 

recommendations. 

Preventing Excessive Procyclicality: Some financial institutions 

have criticized the use of mark-to-market accounting in the current 

environment as overstating losses, diminishing bank capital, and 

exacerbating the crisis. Others have applauded its use as essential 

in promptly revealing the extent of problem assets and the deteriorating financial condition of institutions. Investment companies, as 

investors in securities, rely upon financial reporting that accurately 

portrays the results and financial position of companies competing 

for investment capital. ICI supports the work of the Financial Accounting Standards Board and its mission to develop financial reporting standards that provide investors with relevant, reliable and 

transparent information about corporate financial performance. 
304 

Certainly, regulatory policies and accounting rules should not induce excessive procyclicality. At the same time, accounting standards should not be modified to achieve any objective other than fair 

and accurate reporting to investors and the capital markets. Any 

concerns regarding the procyclical effects of mark-to-market accounting on lending institutions’ capital may be better addressed 

through changes to capital standards themselves. Consideration 

should be given to, for example, developing countercyclical capital 

standards and requiring depositaries and other institutions to build 

up capital more amply in favorable market conditions and thus position themselves to weather unfavorable conditions more easily. 

Monitoring and Addressing Systemic Risk: Over the past year, 

various policymakers and other commentators have called for the 

establishment of a formal mechanism for identifying, monitoring, 

and managing risks to the financial system as a whole. ICI concurs 

with those commentators that creation of such a mechanism is necessary. The ongoing financial crisis has highlighted the vulnerability of our financial system to risks that have the potential to 

spread rapidly throughout the system and cause significant damage. A mechanism that will allow Federal regulators to look across 

the system should equip them to better anticipate and address 

such risks. 

In its recent white paper on regulatory reform, ICI endorsed the 

designation of a new or existing agency or inter-agency body as a 

‘‘Systemic Risk Regulator.’’ Broadly stated, the goal in establishing 

a Systemic Risk Regulator should be to provide greater overall stability to the financial system as a whole. The Systemic Risk Regulator should have responsibility for: (1) monitoring the financial 

markets broadly; (2) analyzing changing conditions in domestic and 

overseas markets; (3) evaluating the risks of practices as they 

evolve and identifying those that are of such nature and extent 

that they implicate the health of the financial system at large; and 

(4) acting to mitigate such risks in coordination with other responsible regulators. 

In ICI’s view, Congress should determine the composition and 

authority of the Systemic Risk Regulator with two important cautions in mind. First, the legislation establishing the Systemic Risk 

Regulator should be crafted to avoid imposing undue constraints or 

inapposite forms of regulation on normally functioning elements of 

the financial system, or stifling innovations, competition or efficiencies. Second, the Systemic Risk Regulator should not be structured to simply add another layer of bureaucracy or to displace the 

primary regulator(s) responsible for capital markets, banking or insurance. Rather, the Systemic Risk Regulator should focus principally on protecting the financial system—as discussed in detail in 

our white paper, we believe that a strong and independent Capital 

Markets Regulator (or, until such agency is established by Congress, the SEC) should focus principally on the equally important 

mandates of protecting investors and maintaining market integrity. 

Legislation establishing the Systemic Risk Regulator should define the nature of the relationship between this new regulator and 

the primary regulator(s) for each industry sector. This should involve carefully defining the extent of the authority granted to the 

Systemic Risk Regulator, as well as identifying circumstances 
305 

under which the Systemic Risk Regulator and primary regulator(s) 

should coordinate their efforts and work together. We believe, for 

example, that the primary regulators have a critical role to play by 

acting as the first line of defense with regard to detecting potential 

risks within their spheres of expertise. 

We recognize that it may be appropriate, for example, to lodge 

responsibility for ensuring effective consolidated global supervision 

of the largest bank holding companies with a designated regulator 

such as the Federal Reserve Board. Beyond this context, however, 

and in view of the two cautions outlined above, ICI believes that 

responsibility for systemic risk management more broadly should 

be assigned to a Systemic Risk Regulator structured as a statutory 

council comprised of senior Federal regulators. Membership should 

include, at a minimum, the Secretary of the Treasury, Chairman 

of the Federal Reserve Board of Governors, and the heads of the 

Federal bank and capital markets regulators (and insurance regulator, if one emerges at the Federal level). 

Q.2. Would a merger or rationalization of the roles of the SEC and 

CFTC be a valuable reform, and how should that be accomplished? 

A.2. Establishment of a New Capital Markets Regulator: ICI 

strongly believes that a merger or rationalization of the roles of the 

Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) would be a valuable reform. 

Currently, securities and futures are subject to separate regulatory 

regimes under different Federal regulators. This system reflects 

historical circumstances that have changed significantly. As recently as the mid-1970s, for example, agricultural products accounted for most of the total U.S. futures exchange trading volume. 

By the late 1980s, a shift from the predominance of agricultural 

products to financial instruments and currencies was readily apparent in the volume of trading on U.S. futures exchanges. In addition, as new, innovative financial instruments were developed, the 

lines between securities and futures often became blurred. The existing, divided regulatory approach has resulted in jurisdictional 

disputes, regulatory inefficiency, and gaps in investor protection 

and market oversight. With the increasing convergence of securities and futures products, markets, and market participants, the 

current system simply makes no sense. To bring a consistent policy 

focus to U.S. capital markets, ICI strongly recommends the creation of a Capital Markets Regulator as a new agency that would 

encompass the combined functions of the SEC and those of the 

CFTC that are not agriculture-related. 

As the Federal regulator responsible for overseeing all financial 

investment products, it is imperative that the Capital Markets Regulator—like the SEC and the CFTC—be established by Congress as 

an independent agency, with an express statutory mission and the 

rulemaking and enforcement powers necessary to carry out that 

mission. A critical part of that mission should be for the new agency to maintain a sharp focus on investor protection and law enforcement. And Congress should ensure that the agency is given 

the resources it needs to fulfill its mission. Most notably, the Capital Markets Regulator must have the ability to attract personnel 
306 

3See Financial Services Regulatory Reform: Discussion and Recommendations, which is available at http://www.ici.org/pdf/pprl09lreglreform.pdf. We note that the white paper was included as an attachment to ICI’s written testimony. 

with the necessary market experience to fully grasp the complexities of today’s global marketplace. 

To preserve regulatory efficiencies achieved under the National 

Securities Markets Improvement Act of 1996, Congress should affirm the role of the Capital Markets Regulator as the regulatory 

standard setter for all registered investment companies. ICI further envisions the Capital Markets Regulator as the first line of defense with respect to identifying and addressing risks across the 

capital markets. The new agency should be granted explicit authority to regulate in certain areas where there are currently gaps in 

regulation—in particular, with regard to hedge funds, derivatives, 

and municipal securities—and explicit authority to harmonize the 

legal standards applicable to investment advisers and 

brokerdealers. These areas are discussed in greater detail in ICI’s 

March 3, 2009, white paper, Financial Services Regulatory Reform: 

Discussion and Recommendations. 3

Organization and Management of the Capital Markets Regulator: 

In the private sector, a company’s success is directly related to the 

soundness of its management. The same principle holds true for 

public sector entities. Establishing a new agency presents a very 

valuable opportunity to ‘‘get it right’’ as part of that process. There 

is also an opportunity to make sound decisions up-front about how 

to organize the new agency. In so doing, it is important not to simply use the current structure of the SEC and/or the CFTC as a 

starting point. The SEC’s current organizational structure, for example, largely took shape in the early 1970s and reflects the operation of the securities markets of that day. Rather, the objective 

should be to build an organization that not only is more reflective 

of today’s markets, market participants and investment products, 

but also will be flexible enough to regulate the markets and products of tomorrow. 

ICI offers the following thoughts with regard to organization and 

management of the Capital Markets Regulator: 

• Ensure high-level focus on agency management. One approach 

would be to designate a Chief Operating Officer for this purpose. 

• Implement a comprehensive process for setting regulatory priorities and assessing progress. It may be helpful to draw upon 

the experience of the United Kingdom’s Financial Services Authority, which seeks to follow a methodical approach that includes developing a detailed annual business plan establishing 

agency priorities and then reporting annually the agency’s 

progress in meeting prescribed benchmarks. 

• Promote open and effective lines of communication among the 

regulator’s Commissioners and between its Commissioners and 

staff. Such communication is critical to fostering awareness of 

issues and problems as they arise, thus increasing the likelihood that the regulator will be able to act promptly and effectively. A range of approaches may be appropriate to consider 

in meeting this goal, including whether sufficient flexibility is 
307 

4See SEC, CFTC Sign Agreement to Enhance Coordination, Facilitate Review of New Derivative Products (SEC press release dated March 11, 2008), available at http://www.sec.gov/news/ 

press/2008/2008-40.htm 

provided under the Government in the Sunshine Act, and 

whether the number of Commissioners should be greater than 

the current number at the SEC and at the CFTC (currently, 

each agency has five). 

• Align the inspections and examinations functions and the policymaking divisions. This approach would have the benefit of 

keeping staff in the policymaking divisions updated on current 

market and industry developments, as well as precluding any 

de facto rulemaking by the regulator’s inspections staff. 

• Develop mechanisms to facilitate coordination and information 

sharing among the policymaking divisions. These mechanisms 

would help to ensure that the regulator speaks with one voice. 

Process of Merging the SEC and CFTC: Legislation to merge the 

SEC and CFTC should outline a process by which to harmonize the 

very different regulatory philosophies of the two agencies, as well 

as to rationalize their governing statutes and current regulations. 

There is potential peril in leaving open-ended the process of merging the two agencies. ICI accordingly recommends that the legislation creating the Capital Markets Regulator set forth a specific 

timetable, with periodic benchmarks and accountability requirements, to ensure that the merger of the SEC and CFTC is completed as expeditiously as possible. 

The process of merging the two agencies will be lengthy, complex, and have the potential to disrupt the functioning of the SEC, 

CFTC, and their regulated industries. ICI suggests that, in anticipation of the merger, the SEC and CFTC undertake detailed consultation on all relevant issues and take all steps possible toward 

greater harmonization of the agencies. This work should be facilitated by the Memorandum of Understanding the two agencies 

signed last year regarding coordination in areas of common regulatory interest. 4 ICI believes that its recommendations with respect 

to the Capital Markets Regulator, outlined in detail in its white 

paper, may provide a helpful framework for these efforts. 

Q.3. How is it that AIG was able to take such large positions that 

it became a threat to the entire Financial system? Was it a failure 

of regulation, a failure of a product, a failure of risk management, 

or some combination? 

A.3. ICI does not have particular insight to offer with regard to 

AIG, the size of its positions in credit default swaps (CDS), and the 

effect that those positions ultimately had on the broader financial 

markets. Nevertheless, our sense is that the answers lie in a combination of all the factors outlined above. We note that Congress 

seems poised to establish a bipartisan commission to investigate 

the causes of the current financial crisis. A thorough examination 

of what happened with AIG would no doubt be a very useful part 

of the commission’s inquiry. 

With regard to CDS generally, ICI believes that a single independent Federal regulator for capital markets should have clear 

authority to adopt measures to increase transparency and reduce 
308 

5 In our March 3, 2009 white paper, Financial Services Regulatory Reform: Discussion and 

Recommendations (which is available at http://www.ici.org/pdf/pprl09lreglreform.pdf), ICI 

recommended the creation of a Capital Markets Regulator as a new agency that would encompass the combined functions of the SEC and those of the CFTC that are not agriculture-related. 

To the extent that no Capital Markets Regulator is formed, we believe that the SEC is the regulator best suited to provide effective oversight of financial derivatives, including CDS. 6See Treasury Proposes Legislation for Resolution Authority (March 25, 2009), available at 

http://www.treas.gov/press/releases/tg70.htm 

counterparty risk, while not unduly stifling innovation. 5 We support current initiatives toward centralized clearing for CDS, which 

should help to reduce counterparty risk and bring transparency to 

trading in the types of CDS that can be standardized. Not all CDS 

are sufficiently standardized to be centrally cleared, however, and 

institutional investors will continue to need to conduct over-the 

counter transactions in CDS. For those transactions, we support 

reasonable reporting requirements, in order to ensure that regulators have enough data on the CDS market to provide effective 

oversight. Finally, we believe that all institutional market participants should be required to periodically disclose their CDS positions publicly, as funds are currently required to do. 

Q.4. How should we update our rules and guidelines to address the 

potential failure of a systematically critical firm? 

A.4. Experience during the financial crisis has prompted calls to establish a better process for dealing with large, diversified financial 

institutions whose solvency problems could have significant adverse 

effects on the financial system or the broader economy. Depository 

institutions already have in place a resolution framework administered by the Federal Deposit Insurance Corporation. In contrast, 

other ‘‘systemically important’’ financial institutions facing insolvency either have to rely on financial assistance from the government (as was the case with AIG) or file for bankruptcy (as was the 

case with Lehman Brothers). 

The Treasury Department has expressed concern that these ‘‘options do not provide the government with the necessary tools to 

manage the resolution of [a financial institution] efficiently and effectively in a manner that limits systemic risk with the least cost 

to the taxpayer.’’ 6 Treasury has sent draft legislation to Congress 

that is designed to address this concern. The legislation would authorize the FDIC to take a variety of actions (including appointing 

itself as conservator or receiver) with respect to a ‘‘financial company’’ if the Treasury Secretary, in consultation with the President 

and based on the written recommendation of the Federal Reserve 

Board and the ‘‘appropriate Federal regulatory agency,’’ makes a 

systemic risk determination concerning that company. 

ICI agrees that it would be helpful to establish rules governing 

the resolution of certain large, diversified financial institutions in 

order to minimize the impact of the potential failure of such an institution on the financial system and consumers as a whole. Such 

a resolution process could benefit investors, including investment 

companies (and their shareholders). The rules for a federally-facilitated wind down should be clearly established so that creditors and 

other market participants understand the process that will be followed and the likely ramifications. Uncertainty associated with ad 

hoc approaches that differ from one resolution to the next will be 

very destabilizing to the financial markets. Clear rules and a trans-
309 

7See Financial Services Regulatory Reform: Discussion and Recommendations, which is available at http://www.ici.org/pdf/pprl09lreglreform.pdf. We note that the white paper was included as an attachment to ICI’s written testimony. 

parent process are critical to bolster confidence and avoid potentially creating reluctance on the part of market participants to 

transact with an institution that is perceived to be ‘‘systemically 

important.’’ 

In determining which institutions might be subject to this resolution process, we recommend taking into consideration not simply 

‘‘size’’ or the specific type of institution but critical factors such as 

the nature and extent of an institution’s leverage and trading positions, the nature of its borrowing relationships, the amount of difficult-to-value assets on its books, its off-balance sheet liabilities, 

and the degree to which it engages in activities that are opaque or 

unregulated. 

More broadly, the reforms recommended in ICI’s recent white 

paper, 7 if enacted, would lead to better supervision of systemically 

critical financial institutions and would help avoid in the future the 

types of situations that have arisen in the financial crisis, such as 

the failure or near failure of systemically important firms. Our recommendations include: 

• Establishing a ‘‘Systemic Risk Regulator’’ that would identify, 

monitor and manage risks to the financial system as a whole; 

• Creating a consolidated Capital Markets Regulator that would 

encompass the combined functions of the Securities and Exchange Commission and those of the Commodity Futures Trading Commission that are not agriculture-related; 

• Considering consolidation of the regulatory structure for the 

banking sector; 

• Authorizing an optional Federal charter for insurance companies; and 

• Promoting effective coordination and information sharing 

among the various financial regulators. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD 

FROM MERCER E. BULLARD 

Q.1. Transparency: Are there additional types of disclosures that 

Congress should require securities market participants to make for 

the benefit of investors and the markets? 

Also, would you recommend more transparency for investors: 

1. By publicly held banks and other financial firms of off-balance 

sheet liabilities or other data? 

2. By credit rating agencies of their ratings methodologies or 

other matters? 

3. By municipal issuers of their periodic financial statements or 

other data? 

4. By publicly held banks, securities firms and GSEs of their risk 

management policies and practices, with specificity and timeliness? 

A.1. Witness declined to respond to written questions for the 

record. 
310 

Q.2. Conflicts of Interest: Concerns about the impact of conflicts of 

interest that are not properly managed have been frequently raised 

in many contexts—regarding accountants, compensation consultants, credit rating agencies, and others. For example, Mr. Turner 

pointed to the conflict of the board of FINRA including representatives of firms that it regulates. The Millstein Center for Corporate 

Governance and Performance at the Yale School of Management in 

New Haven, Connecticut on March 2 proposed an industry-wide 

code of professional conduct for proxy services that includes a ban 

on a vote advisor performing consulting work for a company about 

which it provides recommendations. 

In what ways do you see conflicts of interest affecting the integrity of the markets or investor protection? Are there conflicts affecting the securities markets and its participants that Congress 

should seek to limit or prohibit? 

A.2. Witness declined to respond to written questions for the 

record. 

Q.3. Credit Default Swaps: There seems to be a consensus among 

the financial industry, government officials, and industry observers 

that bringing derivative instruments such as credit default swaps 

under increased regulatory oversight would be beneficial to the nation’s economy. Please summarize your recommendations on the 

best way to oversee these instruments. 

A.3. Witness declined to respond to written questions for the 

record. 

Q.4. Corporate Governance—Majority Vote for Directors, Proxy Access, Say on Pay: The Council of Institutional Investors, which represents public, union and corporate pension funds with combined 

assets that exceed $3 trillion, has called for ‘‘meaningful investor 

oversight of management and boards’’ and in a letter dated December 2, 2008, identified several corporate governance provisions that 

‘‘any financial markets regulatory reform legislation [should] include.’’ Please explain your views on the following corporate governance issues: 

1. Requiring a majority shareholder vote for directors to be elected in uncontested elections; 

2. Allowing shareowners the right to submit amendment to 

proxy statements; 

3. Allowing advisory shareowner votes on executive cash compensation plans. 

A.4. Witness declined to respond to written questions for the 

record. 

Q.5. Credit Rating Agencies: Please identify any legislative or regulatory changes you believe are warranted to improve the oversight 

of credit rating agencies. 

In addition, I would like to ask your views on two specific proposals: 

1. The Peterson Institute report on ‘‘Reforming Financial Regulation, Supervision, and Oversight’’ recommended reducing 

conflicts of interest in the major rating agencies by not per-
311 

mitting them to perform consulting activities for the firms 

they rate. 

2. The G30 Report ‘‘Financial Reform; A Framework for Financial Stability’’ recommended that regulators should permit 

users of ratings to hold NRSROs accountable for the quality 

of their work product. Similarly, Professor Coffee recommended creating potential legal liability for recklessness 

when ‘‘reasonable efforts’’ have not been made to verify ‘‘essential facts relied upon by its ratings methodology.’’ 

A.5. Witness declined to respond to written questions for the 

record. 

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds Association testified before the House Subcommittee on Capital Markets 

and said: ‘‘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.’’ MFA supported the creation or designation of a ‘‘single 

central systemic risk regulator’’ that (1) has ‘‘the authority to request and receive, on a confidential basis, from those entities that 

it determines . . . 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,’’ (2) has 

a mandate of protection of the financial system, but not investor 

protection or market integrity and (3) has the authority to ensure 

that a failing market participant does not pose a risk to the entire 

financial system. 

Do you agree with MFA’s position? Do you feel there should be 

regulation of hedge funds along these lines or otherwise? 

A.6. Witness declined to respond to written questions for the 

record. 

Q.7. Self-Regulatory Organizations: How do you feel the self-regulatory securities organizations have performed during the current 

financial crisis? Are there changes that should be made to the selfregulatory organizations to improve their performance? Do you feel 

there is still validity in maintaining the self-regulatory structure or 

that some powers should be moved to the SEC or elsewhere? 

A.7. Witness declined to respond to written questions for the 

record. 

Q.8. Structure of the SEC: Please share your views as to whether 

you feel that the current responsibilities and structure of the SEC 

should be changed. 

Please comment on the following specific proposals: 

1. Giving some of the SEC’s duties to a systemic risk regulator 

or to a financial services consumer protection agency; 

2. Combining the SEC into a larger ‘‘prudential’’ financial services regulator; 

3. Adding another Federal regulators’ or self-regulatory organizations’ powers or duties to the SEC. 

A.8. Witness declined to respond to written questions for the 

record. 
312 

Q.9. SEC Staffing, Funding, and Management: The SEC has a 

staff of about 3,500 full-time employees and a budget of $900 million. It has regulatory responsibilities with respect to approximately: 12,000 public companies whose securities are registered 

with it; 11,300 investment advisers; 950 mutual fund complexes; 

5,500 broker-dealers (including 173,000 branch offices and 665,000 

registered representatives); 600 transfer agents, 11 exchanges; 5 

clearing agencies; 10 nationally recognized statistical rating organizations; SROs such as the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board and the Public 

Company Accounting Oversight Board. 

To perform its mission effectively, do you feel that the SEC is appropriately staffed? funded? managed? How would you suggest that 

the Congress could improve the effectiveness of the SEC? 

A.9. Witness declined to respond to written questions for the 

record. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM MERCER E. BULLARD 

Q.1. Do you all agree with Federal Reserve Board Chairman 

Bernanke’s remarks today about the four key elements that should 

guide regulatory reform? 

First, we must address the problem of financial institutions that are deemed too 

big—or perhaps too interconnected—to fail. Second, we must strengthen what 

I will call the financial infrastructure—the systems, rules, and conventions that 

govern trading, payment, clearing, and settlement in financial markets—to ensure that it will perform well under stress. Third, we should review regulatory 

policies and accounting rules to ensure that they do not induce excessive 

procyclicality—that is, do not overly magnify the ups and downs in the financial 

system and the economy. Finally, we should consider whether the creation of 

an authority specifically charged with monitoring and addressing systemic risks 

would help protect the system from financial crises like the one we are currently experiencing. 

Would a merger or rationalization of the roles of the SEC and 

CFTC be a valuable reform, and how should that be accomplished? 

How is it that AIG was able to take such large positions that it 

became a threat to the entire financial system? Was it a failure of 

regulation, a failure of a product, a failure of risk management, or 

some combination? 

How should we update our rules and guidelines to address the 

potential failure of a systematically critical firm? 

A.1. Witness declined to respond to written questions for the 

record. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD 

FROM ROBERT PICKEL 

Q.1. Transparency: Are there additional types of disclosures that 

Congress should require securities market participants to make for 

the benefit of investors and the markets? Also, would you recommend more transparency for investors: 

• By publicly held banks and other financial firms of off-balance 

sheet liabilities or other data? 
313 

• By credit rating agencies of their ratings methodologies or 

other matters? 

• By municipal issuers of their periodic financial statements or 

other data? 

• By publicly held banks, securities firms, and GSEs of their risk 

management policies and practices, with specificity and timeliness? 

A.1. Transparency plays an important role in encouraging market 

participation. At the same time, in some instances proprietary information must be kept confidential in order to encourage market 

participation. There is a balancing act that must be performed with 

respect to when enhanced transparency will assist the proper functioning of a market (which should be the default assumption) and 

when it might prove counter-productive. 

Q.2. Credit Default Swaps: There seems to be a consensus among 

the financial industry, government officials, and industry observers 

that bringing derivative instruments such as credit default swaps 

under increased regulatory oversight would be beneficial to the Nation’s economy. Please summarize your recommendations on the 

best way to oversee these instruments. 

A.2. Credit default swaps play an important role in facilitating financing, and ensuring their continued availability to sophisticated 

market participants is in the best interest of promoting U.S. economic growth. At the same time it is clear that our regulatory system as a whole is in need of reform and restructuring in order to 

accommodate new types of products and markets. CDS and OTC 

derivatives in general are currently subject to a range of oversight, 

extending from regulation of the primary dealers in these markets 

(such as banks), through to different levels of oversight by the 

CFTC and SEC with respect to different types of underlying products. With regard to CDS in particular, change in the current regulatory structure should be focused on ensuring the continued availability of the product while preventing potentially destabilizing regulation of certain types of CDS as insurance at the State level. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM ROBERT PICKEL 

Q.1. Do you all agree with Federal Reserve Board Chairman 

Bernanke’s remarks today about the four key elements that should 

guide regulatory reform? 

First, we must address the problem of financial institutions that are deemed too 

big—or perhaps too interconnected—to fail. Second, we must strengthen what 

I will call the financial infrastructure—the systems, rules, and conventions that 

govern trading, payment, clearing, and settlement in financial markets—to ensure that it will perform well under stress. Third, we should review regulatory 

policies and accounting rules to ensure that they do not induce excessive 

procyclicality—that is, do not overly magnify the ups and downs in the financial 

system and the economy. Finally, we should consider whether the creation of 

an authority specifically charged with monitoring and addressing systemic risks 

would help protect the system from financial crises like the one we are currently experiencing. 

Would a merger or rationalization of the roles of the SEC-and 

CFTC be a valuable reform, and how should that be accomplished? 
314 

How is it that AIG was able to take such large positions that it 

became a threat to the entire financial system? Was it a failure of 

regulation, a failure of a product, a failure of risk management, or 

some combination? 

How should we update our rules and guidelines to address the 

potential failure of a systematically critical firm? 

A.1. ISDA supports legislative efforts to create a governmental authority to monitor, assess and take action to address potential systemic risk within the financial system. This systemic risk regulator 

should have the authority to: monitor large exposures across firms 

and markets; assess potential deficiencies in risk management 

practices; analyze the exposures of highly connected firms; identify 

regulatory gaps; and have the ability to promulgate rules necessary 

to carry out its authorities. The powers of the systemic risk regulator should be focused on markets as a whole, and not limited to 

narrow categories of products or participants. The systemic risk 

regulator should work cooperatively with other regulators globally 

to help promote internationally consistent standards. 

Merger of the SEC and CFTC is a complicated issue which presents many issues extending beyond the OTC derivatives industry. 

The framework of regulation created by the Commodity Futures 

Modernization Act of 2000, which provides elements of oversight of 

OTC derivatives activity by both agencies, has been very successful 

in promoting the growth of the business in the United States. 

AIG’s ability to take large positions appears to stem primarily 

from a failure of AIG to follow widely used, generally accepted best 

practices with respect to collateralization. It appears that a failure 

of prudent risk management as well as lax oversight contributed 

to AIG’s downfall. 

The U.S. Bankruptcy Code and Federal Deposit Insurance Corporation Act provide mechanisms for the orderly wind down of 

qualified financial contracts; these provisions appear to have functioned well during the failures of both banks and non-banks (such 

as Lehman Bros.). 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD 

FROM DAMON A. SILVERS 

Q.1. Transparency: Are there additional types of disclosures that 

Congress should require securities market participants to make for 

the benefit of investors and the markets? 

Also, would you recommend more transparency for investors: 

1. By publicly held banks and other financial firms of off-balance 

sheet liabilities or other data? 

2. By credit rating agencies of their ratings methodologies or 

other matters? 

3. By municipal issuers of their periodic financial statements or 

other data? 

4. By publicly held banks, securities firms and GSEs of their risk 

management policies and practices, with specificity and timeliness? 

A.1. (1) I do not understand why after Enron we continued to allow 

off-balance sheet activities as a general matter. FASB has finally 
315 

acted to tighten the rules on off-balance sheet activity, it is unclear 

whether those efforts will be successful. In my view, if a liability 

is close enough to a company to be called an off-balance sheet liability, it should be on-balance sheet. 

(2) Yes, credit rating agencies should both be required to disclore 

their methods, and should be substantively regulated, much as 

audit firms are, by either the SEC, the PCAOB, or a new agency. 

However, I am opposed to undoing the NRSRO approach to ratings 

agencies, there needs to be a basic minimum standard for firms 

holding themselves out to the public as ratings agencies, just as we 

have such standards for banks, broker dealers, lawyers, etc. 

(3) I am unaware of a good reason there should not be periodic 

financial disclosures by public debt issuers. 

(4) There should be increased disclosure of risk management policies and practices, and there should be changes to SEC current 

practices around shareholder proposals to allow shareholders to file 

proposals under Rule 14a-8 addressing risk management policies 

and the creation of risk management committees of boards in publicly held financial institutions. 

Q.2. Conflicts of Interest: Concerns about the impact of conflicts of 

interest that are not properly managed have been frequently raised 

in many contexts—regarding accountants, compensation consultants, credit rating agencies, and others. For example, Mr. Turner 

pointed to the conflict of the board of FINRA including representatives of firms that it regulates. The Millstein Center for Corporate 

Governance and Performance at the Yale School of Management in 

New Haven, Connecticut on March 2 proposed an industry-wide 

code of professional conduct for proxy services that includes a ban 

on a vote advisor performing consulting work for a company about 

which it provides recommendations. 

In what ways do you see conflicts of interest affecting the integrity of the markets or investor protection? Are there conflicts affecting the securities markets and its participants that Congress 

should seek to limit or prohibit? 

A.2. Conflicts of interest are a permanent feature of our markets, 

where both people and firms have vast webs of relationships. However, certain types of conflicts are simply inconsistent with doing 

the jobs we ask key gatekeepers and intermediaries to perform. I 

do not think it is consistent with the role of proxy advisor to also 

be a hired consultant to the firms whose governance the proxy advisor is supposed to analyze on behalf of investors. 

The crisis should lead Congress to take a close look at conflicts 

of interest in the dealings between originators, servicers, and investors in the mortgage markets and other secondary markets, and in 

the business model of ratings agencies. 

Finally, there is a conflict of interest inherent in executive pay— 

we ask executives to be loyal to the firm they work for, knowing 

that they also will seek to enhance their own personal economic interests through their pay packages. That is why executive pay 

must be closely watched, by boards, by shareholders, by the press, 

and by investors. In this respect, the advisors to board of directors 

in negotiating executive pay should be particularly free of conflict. 

It is inappropriate for executive pay consultants working for boards 
316 

to simultaneously receive lucrative consulting engagements from 

the very CEO’s whose pay they evaluate. This is substantially the 

same problem as infected outside auditors prior to the passage of 

Sarbanes-Oxley. 

Q.3. Credit Default Swaps: There seems to be a consensus among 

the financial industry, government officials, and industry observers 

that bringing derivative instruments such as credit default swaps 

under increased regulatory oversight would be beneficial to the nation’s economy. Please summarize your recommendations on the 

best way to oversee these instruments. 

A.3. Credit default swaps are a form of insurance economically. 

They should be regulated according to the same principles as insurance-full disclosure of terms, and most importantly, capital requirements. 

More generally, credit default swaps are one example of financial 

derivatives, contracts that can replicate any financial transaction 

or investment. It is possible to synthesize an insurance contract, 

e.g., a credit default swap, to synthesize an equity or debt investment through a total return swap, or to synthesize a short position. 

Derivatives need to be regulated based on what they actually are 

economically, or to put it a different way, what the underlying assets are referred to in the derivative contract. So for example, the 

SEC should require the disclosure of synthetic positions in public 

securities under Section 13 of the Securities Exchange Act by large 

investors, just as it requires the disclosure of actual positions. 

A key step in derivatives regulation should be to require all derivatives written based on a standard contract, such as the ISDA 

forms, be traded on exchanges, with transparency to all market 

participants, and collateral requirements. A clearinghouse approach is insufficient because it lacks transparency. Exceptions to 

this requirement should be very narrowly tailored. In this respect, 

as many commentators have noted, the Treasury Department 

White Paper falls short. 

I support and endorse the efforts at closing some of the loopholes 

in the Treasury white paper made in correspondence with Congress 

by CFTC Chairman Gary Gensler. The details of my views are in 

the attached written statement I made to a joint roundtable convened by the SEC and the CFTC on coordinating their regulation 

of derivatives and futures. 

Q.4. Corporate Governance—Majority Vote for Directors, Proxy Access, Say on Pay: The Council of Institutional Investors, which represents public, union and corporate pension funds with combined 

assets that exceed $3 trillion, has called for ‘‘meaningful investor 

oversight of management and boards’’ and in a letter dated December 2, 2008, identified several corporate governance provisions that 

‘‘any financial markets regulatory reform legislation [should] include.’’ Please explain your views on the following corporate governance issues: 

1. Requiring a majority shareholder vote for directors to be elected in uncontested elections; 

2. Allowing shareowners the right to submit amendment to 

proxy statements; 
317 

3. Allowing advisory shareowner votes on executive cash compensation plans. 

A.4. (1) Majority voting has become common practice in corporate 

America in recent years, thanks in large part to the efforts of institutional investors, including workers’ pension funds. I think this is 

a positive development. However, in many cases the form of majority voting is weak, more of a guideline than a rule. Companies 

should adopt clear bylaws embodying the principle of majority voting. 

(2) I believe this question is designed to get at the SEC’s somewhat convoluted decision to reverse the court’s finding in AIG v. 

AFSCME and bar shareholder proposals addressing proxy access, 

the right of shareholder nominated directors, if they enjoy substantial shareholder support, to appear on the company’s proxy materials. This decision was mistaken and should be reversed. Furthermore, the SEC should move promptly to adopt a mandatory floor 

process for proxy access. Proxy access makes real the mandate to 

the Commission under Section 14 of the Securities Exchange Act 

to ensure that proxies fairly represent the agenda before company 

annual meetings. When shareholder nominated candidates have 

significant support, their candidacy is clearly a relevant fact that 

shareholders should be aware of when the management solicits 

their vote. I strongly support the draft rule proposed by the Commission earlier this summer, and urge Congress to support the 

Commission in this effort. 

(3) Shareholder advisory votes on executive pay have been a feature of the corporate governance system in the United Kingdom for 

several years. Pension funds in the UK are strongly supportive of 

this measure, and that enthusiasm is shared by institutional investors in the United States. It is important to note that in the UK 

say on pay is advisory, and most proposals I am aware of for adopting the practice in the United States are for an advisory vote. 

I should note that say on pay might not be necessary if boards 

were strong on the issue of executive pay. But after 20 years of 

runaway executive pay, it seems clearly necessary to involve shareholders directly in trying to control this excess. 

Q.5. Credit Rating Agencies: Please identify any legislative or regulatory changes you believe are warranted to improve the oversight 

of credit rating agencies. 

In addition, I would like to ask your views on two specific proposals: 

1. The Peterson Institute report on ‘‘Reforming Financial Regulation, Supervision, and Oversight’’ recommended reducing 

conflicts of interest in the major rating agencies by not permitting them to perform consulting activities for the firms 

they rate. 

2. The G30 Report ‘‘Financial Reform; A Framework for Financial Stability’’ recommended that regulators should permit 

users of ratings to hold NRSROs accountable for the quality 

of their work product. Similarly, Professor Coffee recommended creating potential legal liability for recklessness 

when ‘‘reasonable efforts’’ have not been made to verify ‘‘essential facts relied upon by its ratings methodology.’’ 
318 

A.5. Please see my answer to Question 1 from Chairman Dodd in 

terms of general reforms to the regulation of credit ratings agencies. 

For the reasons discussed above in response to a general question on conflicts of interest, I think a ban on side consulting arrangements for credit rating agencies is appropriate and necessary. 

I do not see how the NRSRO structure, which makes clear that 

rating agencies are acting as a gatekeeper, is consistent with absolute legal immunity for misconduct in the role of gatekeeper. On 

the other hand, Congress should recognize the reality that credit 

rating agencies cannot act as insurers of the credit market. The 

way to do that is to have liability standards that recognize liability 

for extraordinary misconduct, and to pair that liability regime with 

a strong regime of oversight and inspection, modeled on that created by the Sarbanes-Oxley Act for auditors. Professor Coffee’s formulation of such a thoughtful liability standard seems reasonable 

to me. As a general matter, the AFL–CIO supports the approach 

taken to these issues in S. 1073, the Rating Accountability and 

Transparency Enhancement Act of 2009, and we are appreciative 

of Senator Reed’s leadership on this issue. 

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds Association testified before the House Subcommittee on Capital Markets 

and said: ‘‘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.’’ MFA supported the creation or designation of a ‘‘single 

central systemic risk regulator’’ that (1) has ‘‘the authority to request and receive, on a confidential basis, from those entities that 

it determines . . . 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,’’ (2) has 

a mandate of protection of the financial system, but not investor 

protection or market integrity and (3) has the authority to ensure 

that a failing market participant does not pose a risk to the entire 

financial system. 

Do you agree with MFA’s position? Do you feel there should be 

regulation of hedge funds along these lines or otherwise? 

A.6. It is true that hedge funds as a group, and certain large funds, 

are systemically significant. It is also true that hedge funds are not 

a distinct form of economic activity, they are a legal structure designed to enable people who manage money to evade regulatory 

oversight. If regulatory arbitrage of this type is allowed to continue, we will repeat the events of 2008, and probably with greater 

severity. 

Thus the MFA position is an effort to avoid oversight by the 

SEC, to perpetuate regulatory arbitrage in our system of financial 

regulation and to prevent meaningful regulation of hedge funds in 

the public interest, and meaningful protection of hedge fund investors. It also illustrates the danger that systemic risk regulation 

can, in the wrong hands, be a vehicle for insulating irresponsible 

market practices from effective regulation. 

The AFL–CIO strongly supports the Treasury Department’s recommendation that Congress require hedge fund and private equity 
319 

fund managers to register as investment advisors with the Securities and Exchange Commission. However, regulating the manager 

is not sufficient. Congress should adopt a regulatory framework for 

hedge funds and private equity funds themselves, a version of the 

Investment Company Act that recognizes these funds are different 

than mutual funds, but nonetheless are money management enterprises profoundly embedded in our public markets. Such regulation 

should recognize that hedge funds are not directly marketed to the 

general public, but the general public is exposed to hedge fund 

risks through pension funds, university endowments, and foundations. Most importantly, giving the SEC clear jurisdiction over the 

fund itself would enable the Commission to oversee the governance 

of these funds and to ensure they operate in the best interests of 

their investors. 

Ultimately, no financial reform is more important than closing 

jurisdictional loopholes in ways that will not allow new loopholes 

to open. This was the genius of the New Deal securities laws until 

they began to be eaten away during the 1980s and 1990s. We need 

to restore this type of comprehensive regulatory approach to SEC 

jurisdiction. 

The MFA’s proposal is to do the opposite. 

Q.7. Self-Regulatory Organizations: How do you feel the self-regulatory securities organizations have performed during the current 

financial crisis? Are there changes that should be made to the selfregulatory organizations to improve their performance? Do you feel 

there is still validity in maintaining the self-regulatory structure or 

that some powers should be moved to the SEC or elsewhere? 

A.7. In general, I am not supportive of self-regulatory structures. 

I think there is however a general view among investors that 

NASD is superior to the structures that preceeded it. It is not clear 

to me that given the scale of what NASD does, it makes sense to 

bring it within the SEC. However, I think Congress may want to 

look closely at the NASD’s governance, and those regulatory functions that remain with the exchanges themselves, to see if NASD’s 

governance can be improved, and to see whether it is sensible for 

any regulatory functions to remain with the exchanges. Part of this 

examination should include an in-depth look at how the NASD and 

the exchanges performed their functions during the runup to the 

financial crisis. In this respect, the new Financial Crisis Commission chaired by Philip Angelides may be helpful. 

Q.8. Structure of the SEC: Please share your views as to whether 

you feel that the current responsibilities and structure of the SEC 

should be changed. 

Please comment on the following specific proposals: 

1. Giving some of the SEC’s duties to a systemic risk regulator 

or to a financial services consumer protection agency; 

2. Combining the SEC into a larger ‘‘prudential’’ financial services regulator; 

3. Adding another Federal regulators’ or self-regulatory organizations’ powers or duties to the SEC. 

A.8. In general, the SEC’s needs expanded jurisidiction to cover all 

financial products that interact with the public markets-derivatives 
320 

linked to publically traded securities, financial futures, hedge funds 

and private equity funds. As I mentioned above, the lack of comprehensive jurisdiction that cannot be evaded is the principal structural problem facing the SEC. 

The AFL–CIO strongly supports the Treasury Department’s proposal for creating a consumer financial protection agency with the 

jurisdiction outlined in the Treasury’s report. That jurisdiction does 

not include taking anything away from the SEC. Investments are 

different than financial services such as mortgages, credit cards, 

and bank accounts, and need to be regulated in a consolidated way 

by the SEC. 

As to taking away responsibilities from the SEC and giving them 

to a systemic risk regulator, that would be an invitation to further 

regulatory arbitrage, and would be opposed by the AFL–CIO. See 

my answer to Question 6 for an example of why this would be a 

bad idea. 

The SEC is fundamentally about ensuring that we have fair and 

transparent securities market. It is not about protecting the safety 

and soundness of particular participants in that market. Merging 

those two obligations would ensure we will have unfair and opaque 

securities markets, run in the interests of ensuring the safety and 

soundness of issuers. 

Congress should in general keep in mind that safety and soundness, consumer protection and investor protection are three distinct, important regulatory functions that are nonetheless in tension with each other. They need to be as much as possible consolidated within each category, but kept in separate categories. Much 

of the failure of regulation in the mortgage bubble came from asking the Federal Reserve to be both guardian of safety and soundness of bank holding companies, and protector of consumers in the 

mortgage market. Ultimately the Fed did neither effectively. Some 

of the most embarrassing moments of the financial crisis have 

come from efforts to have the same people make decisions about 

safety and soundness and investor protection, most notably at 

Bank of America. These incidents should not be the model of our 

regulatory future. 

I think that the CFTC should be merged with the SEC, or alternatively its financial jurisdiction, as opposed to its jurisdiction over 

instruments linked to physical commodities, should be transferred 

to the SEC in the interests of preventing regulatory arbitrage. As 

to the NASD and the exchanges, see my answer to Question 7. 

Q.9. SEC Staffing, Funding, and Management: The SEC has a 

staff of about 3,500 full-time employees and a budget of $900 million. It has regulatory responsibilities with respect to approximately: 12,000 public companies whose securities are registered 

with it; 11,300 investment advisers; 950 mutual fund complexes; 

5,500 broker-dealers (including 173,000 branch offices and 665,000 

registered representatives); 600 transfer agents, 11 exchanges; 5 

clearing agencies; 10 nationally recognized statistical rating organizations; SROs such as the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board and the Public 

Company Accounting Oversight Board. 
321 

To perform its mission effectively, do you feel that the SEC is appropriately staffed? funded? managed? How would you suggest that 

the Congress could improve the effectiveness of the SEC? 

A.9. The SEC is underfunded, and suffers from funding uncertainty. In the immediate aftermath of disasters like Enron, the 

SEC gets big budget increases, only to see them taken away when 

the spotlight moves on. The consequences for the Commission go 

beyond a general lack of resources to profound difficulties in attracting and developing career staff. 

The AFL–CIO supports both substantial budget increases and 

dedicated funding for the Commission similar to that which the 

Board of Governors of the Federal Reserve enjoys. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM DAMON A. SILVERS 

Q.1. Do you all agree with Federal Reserve Board Chairman 

Bernanke’s remarks today about the four key elements that should 

guide regulatory reform? 

First, we must address the problem of financial institutions that are deemed too 

big—or perhaps too interconnected—to fail. Second, we must strengthen what 

I will call the financial infrastructure—the systems, rules, and conventions that 

govern trading, payment, clearing, and settlement in financial markets—to ensure that it will perform well under stress. Third, we should review regulatory 

policies and accounting rules to ensure that they do not induce excessive 

procyclicality—that is, do not overly magnify the ups and downs in the financial 

system and the economy. Finally, we should consider whether the creation of 

an authority specifically charged with monitoring and addressing systemic risks 

would help protect the system from financial crises like the one we are currently experiencing. 

A.1. I would cover some of the same ground that Chairman 

Bernanke did in a different way. I think regulatory reform must: 

1. Protect the public by creating an independent consumer protection agency for financial services, which would, among 

other duties, ensure mortgage markets are properly regulated 

2. Reregulate the shadow markets-in particular, derivatives, 

hedge funds, private equity funds, and off-balance sheet vehicles, so that it is no longer possible for market actors to choose 

to conduct activities like bond insurance or money management either in a regulated or an unregulated manner. As 

President Obama said in 2008 at Cooper Union, financial activity should be regulated for its content, not its form. 

3. Provide for systemic risk regulation by a fully public entity, 

including the creation of a resolution mechanism applicable to 

any financial firm that would be the potential subject of government support. The Federal Reserve System under its current governance structure, which includes significant bank involvement at the Reserve Banks, is too self-regulatory to be 

a proper systemic risk regulator. Either the Federal Reserve 

System needs to be fully public, or the systemic risk regulatory function needs to reside elsewhere, perhaps in a committee that would include the Fed Chairman in its leadership. 

The issue of procyclicality is complex. I think anticyclicality in 

capital requirements may be a good idea. I have become very skep-
322 

tical of the changes that have been made to GAAP that have had 

the effect, in my opinion, of making financial institutions’ balance 

sheets and income statements less transparent and reliable. See 

the August, 2009, report of the Congressional Oversight Panel. 

Most importantly, moves that appear to be anticyclical may be 

procyclical, by allowing banks not to write down assets that are in 

fact impaired, these measures may be a disincentive, for example, 

for banks to restructure mortgages in ways that allow homeowners 

to stay in their homes. 

Q.2. Would a merger or rationalization of the roles of the SEC and 

CFTC be a valuable reform, and how should that be accomplished? 

A.2. A merger of the SEC and the CFTC would be a valuable reform. Alternatively, jurisdiction over financial futures and derivatives could be transferred from the CFTC to the SEC so that there 

is no possibility of regulatory arbitrage between securities on the 

one hand and financial futures and derivatives on the other. Recent 

efforts by both agencies to harmonize their approaches to financial 

regulation, while productive, have highlighted the degree to which 

they are regulating the same market, and the extent of the continuing threat of regulatory arbitrage created by having separate 

agencies. 

If there were to be a merger, it must be based on adopting the 

SEC’s greater anti-fraud and market oversight powers. The worst 

idea that has surfaced in the entire regulatory reform debate, going 

back to 2006, was the proposal in the Paulson Treasury blueprint 

to use an SEC-CFTC merger to gut the investor protection and enforcement powers of the SEC. 

For more details on these issues, the Committee should review 

the transcript of the second day of the joint SEC-CFTC roundtable 

on coordination issues held on September 3, 2009. I have attached 

my written statement to that roundtable. [See, Joint Hearing Testimony, below.] 

Q.3. How is it that AIG was able to take such large positions that 

it became a threat to the entire financial system? Was it a failure 

of regulation, a failure of a product, a failure of risk management, 

or some combination? 

A.3. AIG took advantage of three regulatory loopholes that should 

be closed. Their London-based derivatives office was part of a thrift 

bank, regulated by the OTS, an agency which during the period in 

question advertised itself to potential ‘‘customers’’ as a compliant 

regulator. This ability to play regulators off against each other 

needs to end. Second, the Basel II capital standards for banks allowed banks with AAA ratings not to have to set capital aside to 

back up derivatives commitments. Third, thanks to the Commodities Futures Modernization Act, there was no ability of any agency 

to regulate derivatives as products, or to require capital to be set 

aside to back derivative positions. 

Within AIG, the large positions taken by the London affiliate 

represent a colossal managerial and governance failure. It is a 

managerial failure in that monitoring capital at risk and leverage 

is a central managerial function in a financial institution. It is a 

governance failure in that the scale of the London operation, and 

its apparent contribution to AIG’s profits in the runup to the col-
323 

lapse, was such that the oversight of the operation should have 

been of some importance to the board. The question now is, what 

sort of accountability has there really been for these failures? 

Q.4. How should we update our rules and guidelines to address the 

potential failure of a systematically critical firm? 

A.4. We need to make the following changes to our financial regulatory system to address the need to protect the financial system 

against systemic risk: 

1. We need to give the FDIC and a systemic risk regulator the 

power to resolve any financial institution, much as that power 

is now given to the FDIC to resolve insured depositary institutions, if that financial institution represents a systemic threat. 

2. Capital requirements and deposit insurance premiums need to 

increase as a percentage of assets as the size of the firm increases. The Obama Administration has proposed a two tier 

approach to this idea. More of a continuous curve would be 

better for a number of reasons—in particular it would not tie 

the hands of policy makers when a firm fails in the way a two 

tier system would. If we have a two tier system, the names 

of the firm in the top tier must be made public. These measures both operate as a deterrent to bigness, and compensate 

the government for the increased likelihood that we will have 

to rescue larger institutions. 

3. Bank supervisory regulators need to pay much closer attention to executive compensation structures in financial institutions to ensure they are built around the proper time horizons 

and the proper orientation around risk. This is not just true 

for the CEO and other top executives—it is particularly relevant for key middle management employees in areas like 

trading desks and internal audit. Fire alarms should go off if 

internal audit is getting incentive pay based on stock price. 

4. We need to close regulatory loopholes in the shadow markets 

so that all financial activity has adequate capital behind it 

and so regulators have adequate line of site into the entire 

market landscape. This means regulating derivatives, hedge 

funds, private equity and off-balance sheet vehicles based on 

the economic content of what they are doing, not based on 

what they are called. 

5. We need to end regulatory arbitrage, among bank regulators; 

between the SEC and the CFTC, and to the extent possible, 

internationally by creating a global financial regulatory floor. 

6. We need to adopt the recommendation of the Group of Thirty, 

chaired by Paul Volcker, to once again separate proprietary 

securities and derivatives trading from the management of insured deposits. 
324 

1 Congressional Oversight Panel, Special Report on Regulatory Reform, at 22-24 (Jan. 29, 

2009), available at http://cop.senate.gov/documents/cop-012909-report-regulatoryreform.pdf 2 Commodity Futures Modernization Act of 2000, Pub. L. No. 106-554, 114 Stat. 2763 (2000). 

AMERICAN FEDERATION OF LABOR AND CONGRESS OF 

INDUSTRIAL ORGANIZATIONS 

Joint Hearing of the CFTC and the SEC—Harmonization of Regulation 

September 3, 2009 

Good morning Chairman Schapiro and Chairman Gensler. My name is Damon Silvers, I am an Associate General Counsel of the AFL–CIO, and I am the Deputy 

Chair of the Congressional Oversight Panel created under the Emergency Economic 

Stabilization Act of 2008 to oversee the TARP. My testimony reflects my views and 

the views of the AFL–CIO unless otherwise noted, and is not on behalf of the Panel, 

its staff or its chair, Elizabeth Warren. I should however note that a number of the 

points I am making in this testimony were also made in the Congressional Oversight Panel’s Report on Financial Regulatory Reform’s section on reregulating the 

shadow capital markets, and I commend that report to you. 1

Thank you for the opportunity to share my views with you today on how to best 

harmonize regulation by the SEC and the CFTC. Before I begin, I would like to 

thank you both for bringing new life to securities and commodities regulation in this 

country. Your dedication to and enforcement of the laws that ensure fair dealing in 

the financial and commodities markets has never been more important than it is 

today. 

Derivatives are a classic shadow market. To say a financial instrument is a derivative says nothing about its economic content. Derivative contracts can be used to 

synthesize any sort of insurance contract, including most prominently credit insurance. Derivatives can synthesize debt or equity securities, indexes, futures and options. Thus the exclusion of derivatives from regulation by any federal agency in the 

Commodity Futures Modernization Act ensured that derivatives could be used to 

sidestep thoughtful necessary regulations in place throughout our financial system. 2

The deregulation of derivatives was a key step in creating the Swiss cheese regulatory system we have today, a system that has proven to be vulnerable to shocks 

and threatening to the underpinnings of the real economy. The result—incalculable 

harm throughout the world, and harm in particular to working people and their 

benefit funds who were not invited to the party and in too many cases have turned 

out to be paying for the cleanup. 

There are three basic principles that the AFL–CIO believes are essential to the 

successful harmonization of SEC and CFTC regulation and enforcement, and to the 

restoration of effective regulation across our financial system: 

1. Regulators must have broad, flexible jurisdiction over the derivatives markets 

that prevents regulatory arbitrage or the creation of new shadow markets 

under the guise of innovation. 

2. So long as the SEC and the CFTC remain separate agencies, the SEC should 

have authority to regulate all financial markets activities, including derivatives 

that reference financial products. The CFTC should have authority to regulate 

physical commodities markets and all derivatives that reference such commodities. 

3. Anti-fraud and market conduct rules for derivatives must be no less robust 

than the rules for the underlying assets the derivatives reference. 

The Administration’s recently proposed Over-the-Counter Derivatives Markets Act 

of 2009 (‘‘Proposed OTC Act’’) will help to close many, but not all, of the loopholes 

that make it difficult for the SEC and the CFTC to police the derivatives markets. 

It will also make it even more important that the SEC and the CFTC work together 

to ensure that regulation is comprehensive and effective. 

Regulators Must Have Broad, Flexible Jurisdiction Over the Entire Derivatives Market 

Derivatives as a general matter should be traded on fully regulated, publicly 

transparent exchanges. The relevant regulatory agencies should ensure that the exchanges impose tough capital adequacy and margin requirements that reflect the 

risks inherent in contracts. Any entity that markets derivatives products must be 

required to register with the relevant federal regulators and be subject to business 

conduct rules, comprehensive recordkeeping requirements, and strict capital adequacy standards. 
325 

3 Available at http://www.financialstability.gov/docs/regulatoryreform/titleVII.pdf 4Proposed OTC Act § 713(a)(2) (proposing revisions to the Commodity Exchange Act, 7 U.S.C. 

2(j)(3)(A)). 5Letter from Gary Gensler, Chairman of the Commodity Futures Trading Commission, to The 

Honorable Tom Harkin and The Honorable Saxby Chambliss, August 17, 2009, page 4, available 

at http://tradeobservatory.org/library.cfm?refid=106665 

6 15 U.S.C. § 78b. 7See generally The Securities Act of 1933 (15 USC § 77a et seq.); The Securities Exchange 

Act of 1934 (15 USC § 78a et seq.); The Investment Company Act of 1940 (15 USC § 80a-1 et 

seq.); The Investment Advisers Act of 1940 (15 USC § 80b-1 et seq.). 8 7 U.S.C. § 1a(4) provides the CFTC with jurisdiction over agricultural products, metals, energy products, etc. See Commodity Futures Trading Com’n v. International Foreign Currency, 

Inc., 334 F.Supp.2d 305 (E.D.N.Y. 2004), Commodity Futures Trading Com’n v. American Bd. 

of Trade, Inc., 803 F.2d 1242 (2d Cir 1986) discussing the CFTC’s authorities with regard to 

currency derivatives. Since 1975, the CFTC has determined that all futures based on short-term 

and long-term U.S. government debt qualifies as a commodity under the CEA. See CFTC History, available at http://www.cftc.gov/aboutthecftc/historyofthecftc/history—1970s.html. Other 

financial products regulated by the CFTC include security indexes, Mallen v. Merrill Lynch., 605 

F.Supp. 1105 (N.D.Ga.1985). 

The Proposed OTC Act addresses many of the AFL–CIO’s concerns about the current lack of regulation in the derivatives markets. If enacted, the Proposed OTC Act 

would ensure that all derivatives and all dealers face increased transparency, capital adequacy, and business conduct requirements. 3 It would also require heightened regulation and collateral and margin requirements for OTC derivatives. 

The Proposed OTC Act would also require the SEC and CFTC to develop joint 

rules to define the distinction between ‘‘standardized’’ and ‘‘customized’’ derivatives. 4 This would make SEC/CFTC harmonization necessary to the establishment 

of effective derivatives regulation. 

The AFL–CIO believes that the definition of a customized contract should be very 

narrowly tailored. Derivatives should not be permitted to trade over-the-counter 

simply because the counterparties have made minor tweaks to a standard contract. 

If counter-parties are genuinely on opposite sides of some unique risk event that exchange-trading could not accommodate, then they should be required to show that 

that is the case through a unique contract. The presence or absence of significant 

arms-length bargaining will be indicative of whether such uniqueness is genuine, or 

artificial. 

In a recent letter to Senators Harkin and Chambliss, Chairman Gensler flagged 

several areas of the Proposed OTC Act that he believes should be improved. 5 The 

AFL–CIO strongly supports Chairman Gensler’s recommendation that Congress revise the Proposed OTC Act to eliminate exemptions for foreign exchange swaps and 

forwards. We also strongly agree with Chairman Gensler that mandatory clearing 

and exchange trading of standardized swaps must be universally applicable and 

there should not be an exemption for counterparties that are not swap dealers or 

‘‘major swap participants.’’ 

The SEC Should Regulate Financial Markets and the CFTC Should Regulate Commodities Markets 

The SEC was created in 1934, due to Congress’ realization that ‘‘national emergencies . . . are precipitated, intensified, and prolonged by manipulation and sudden and unreasonable fluctuations of security prices and by excessive speculation 

on such exchanges and markets, and to meet such emergencies the Federal Government is put to such great expense as to burden the national credit.’’ 6 As a result 

of the impact instability in the financial markets had on the broader economy during the Great Depression, Congress gave the SEC broad authority to regulate financial markets activities and individuals that participate in the financial markets in 

a meaningful way. 7

As presently constituted, the CFTC has oversight not only for commodities such 

as agricultural products, metals, energy products, but also has come to regulate— 

through court and agency interpretation of the CEA—financial instruments, such as 

currency, futures on U.S. government debt, and security indexes. 8

So long as two agencies continue to regulate the same or similar financial instruments, there will be opportunities for market participants to engage in regulatory 

arbitrage. As we have seen on the banking regulatory side and with respect to credit 

default swaps, such arbitrage can have devastating results. 

As long as the SEC and the CFTC are separate, the SEC should regulate all financial instruments including stocks, bonds, mutual funds, hedge funds, securities, 

securities-based swaps, securities indexes, and swaps that reference currencies, U.S. 

government debt, interest rates, etc. The CFTC should have authority to regulate 

all physical commodities and commodities-based derivatives. 
326 

9 Id. 

We recognize that the proposed Act does not in all cases follow the principles laid 

out above. To the extent financial derivatives remain under the jurisdiction of the 

CFTC, it is critical that the CFTC and the SEC seek the necessary statutory 

changes to bring the CFTC’s power to police fraud and market manipulation in line 

with the SEC’s powers. In this respect, we are heartened by the efforts by the CFTC 

under Chairman Gensler’s leadership to address possible gaps in the Administration’s proposed statutory language. A vigorous and coordinated approach to enforcement by both agencies can in some respects correct for flaws in jurisdictional design. 

They cannot correct for lack of jurisdiction or weak substantive standards of market 

conduct. 

In his letter to Senators Harkin and Chambliss, Chairman Gensler raised concerns about the Administration’s proposal for the regulation of ‘‘mixed swaps,’’ or 

swaps whose value is based on a combination of assets including securities and commodities. Because the underlying asset will include those regulated by both the SEC 

and the CFTC, the Administration proposes that both agencies separately regulate 

these swaps in a form of ‘‘dual regulation.’’ Chairman Gensler expresses concern 

that such dual regulation will be unnecessarily confusing, and suggests instead that 

each mixed swap be assigned to one agency or the other, but not both. In that proposed system, the mixed swap would be ‘‘primarily’’ deriving its economic identity 

from either a security or a commodity. 9 Under the Chairman’s view, only one agency would regulate any given mixed swap, depending on whether the swap was ‘‘primarily’’ a security- or a commodity-based swap. 

Chairman Gensler’s proposal certainly has a great deal of appeal—it’s simpler, 

and eliminates the concern that duplicative regulation becomes either unnecessarily 

burdensome, or worse, completely ineffective. One could imagine a situation where 

each agency defers to the other, leaving mixed swaps dealers with free reign to develop their market as they see fit. 

But a proposal that focuses on the boundary between an SEC mixed swap and 

a CFTC mixed swap will run into a clear problem. There are swaps that are not 

primarily either security- or commodity-based: in fact, by design, they are swaps 

that, at the time of contract, are exactly 50/50, where the economic value of the 

SEC-type asset is equivalent to the economic value of the CFTC based asset. 50/ 

50 swaps aren’t that unusual, and Chairman Gensler’s approach does not address 

what to do in those instances. 

These kinds of boundary issues become inevitable when we decide not to merge 

the two agencies. In order to prevent these problems from becoming loopholes, a solution must either eliminate the boundary—e.g., the Administration’s dual regulation proposal—or it must adequately police that boundary. One potential alternative 

would be to form a staff-level joint task force between the CFTC and the SEC to 

ensure that these 50/50 swaps—those that are neither obviously SEC-swaps nor 

CFTC-swaps—would be regulated comprehensively, and consistently, across the system. 

Anti-Fraud and Market Conduct Rules 

In considering enforcement issues for derivatives, it is critical to consider the appropriate level of regulation of the underlying assets from which these derivatives 

flow. Some of the strongest tools in the agencies’ toolboxes are anti-fraud and market conduct enforcement. Derivatives must be held at a minimum to the same 

standards as the underlying assets. The Administration’s Proposed OTC Derivatives 

Act makes important steps in this direction. However, there will be a continuing 

problem if the rules governing the underlying assets are too weak. 

Here the CFTC’s current statutory framework is substantially weaker in terms 

of both investor protection and market oversight than the SEC. The Commodities 

Exchange Act (CEA) does not recognize insider trading as a violation of the law. 

This is a serious weakness in the context of mixed derivatives and both financial 

futures and derivatives based on financial futures. It also appears to be an obstacle 

to meaningful oversight of the commodities markets themselves in the light of allegations of market manipulation in the context of the recent oil price bubble. 

Similarly, the CEA has an intentionality standard for market manipulation, while 

the SEC operates under a statutory framework where the standard in general is 

recklessness. Intentionality as a standard for financial misconduct tends to require 

that the agency be able to read minds to enforce the law. Recklessness is the proper 

common standard. 
327 

10Financial Regulatory Reform: A New Foundation. Department of the Treasury (June 17, 

2009). See also http://www.financialstability.gov/docs/regs/FinalReportlweb.pdf 11http://www.treas.gov/press/releases/reports/Blueprint.pdf 

Rules Versus Principles 

The Treasury Department’s White Paper on Financial Regulatory Reform suggests there should be a harmonization between the SEC’s more rules-based approach to market regulation and the CFTC’s more principles-based approach. 10 Any 

effective system of financial regulation requires both rules and principles. A system 

of principles alone gives no real guidance to market actors and provides too much 

leeway that can be exploited by the politically well connected. A system of rules 

alone is always gameable. 

Unfortunately, in the years prior to the financial crisis that began in 2007 the 

term ‘‘principles based regulation’’ became a code word for weak regulation. Perhaps 

the most dangerous manifestation of this effort was the Paulson Treasury Department’s call in its financial reform blueprint for the weakening of the SEC’s enforcement regime in the name of principles based regulation by requiring a merged SEC 

and CFTC to adopt the CEA’s approach across the entire securities market. 11

The SEC and the CFTC should build a strong uniform set of regulations for derivatives markets that blend principles and rules. These rules should not be built 

with the goal of facilitating speedy marketing of innovative financial products regardless of the risks to market participants or the system as a whole. In particular, 

the provisions of the Commodities Exchange Act that place the burden on the CFTC 

to show an exchange or clearing facilities operations are not in compliance with the 

Act’s principles under a ‘‘substantial evidence’’ test are unacceptably weak, and if 

adopted in the area of derivatives would make effective policing of derivatives’ exchanges and/or clearinghouses extremely difficult. 

It remains a mystery to us why ‘‘innovation’’ in finance is uncritically accepted 

as a good thing when so much of the innovation of the last decade turned out to 

be so destructive, and when so many commentators have pointed out that the ‘‘innovations’’ in question, like naked credit default swaps with no capital behind them, 

were well known to financial practitioners down through the ages and had been 

banned in our markets for good reason, in some cases during the New Deal and in 

some cases earlier. 

This approach is not a call for splitting the difference between strong and weak 

regulation. It is a call for building strong, consistent regulation that recognizes that 

the promotion of weak regulation under the guise of ‘‘principles based regulation’’ 

was a major contributor to the general failure of the financial regulatory system. 

Conclusion 

The last 2 years have shown us the destructive consequences of the present system—destructive not only to our overall economy, but also to the lives and livelihoods of the men, women, and families least positioned to weather these storms. We 

have seen firsthand how regulatory arbitrage in the financial markets create tremendous systemic risks that can threaten the stability of the global economy. Derivatives are a primary example of how jurisdictional battles among regulators can 

result in unregulated and unstable financial markets. We urge you to work together 

to create a system that will ensure that nothing falls through the cracks when the 

SEC and the CFTC are no longer under your collective leadership. 
328 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD 

FROM THOMAS DOE 

Q.1. Transparency: Are there additional types of disclosures that 

Congress should require securities market participants to make for 

the benefit of investors and the markets? Also, would you recommend more transparency for investors: 

1. By publicly held banks and other financial firms of off-balance 

sheet liabilities or other data? 

2. By credit rating agencies of their ratings methodologies or 

other matters? 

3. By municipal issuers of their periodic financial statements or 

other data? 

4. By publicly held banks, securities firms and GSEs of their risk 

management policies and practices, with specificity and timeliness? 

A.1. In MMA’s written testimony there was extensive discussion regarding the issue of inadequate enforcement of financial disclosure 

by municipal issuers. The greatest inhibiting aspect of disclosure is 

the ambiguity regarding rule 15c2-12. The vagueness of the rule 

has inhibited FINRA from enforcing the regulation and has only 

ensured that investors are not provided with pertinent financial information, but also that taxpayers do not have access to updated 

financial information. 

As the MSRB’s EMMA system approaches July 1 hegemony, participants’ discussions over the problems with municipal disclosure 

have become more heated. Last Thursday, Moody’s Investors Service withdrew more than a dozen local government ratings based on 

issuers’ failure to provide timely financial or operating information. 

Although this does not follow a policy change by Moody’s, it does 

reflect increased resources for surveillance and, in our opinion, is 

a preface to additional rating withdrawals in the coming months. 

In theory, if investors grow more broadly aware that bond ratings 

are vulnerable to disclosure lapses, the offending issuers will be 

forced to pay higher interest rates to borrow in the future. 

The problem: Disclosure failings undermine liquidity in affected 

bonds and have led to mistrust of issuers by investors and, likely, 

modestly higher system-wide interest rates. Disclosure gaps occur 

because the current regulation is both weak and evasive. Rule 

15c2-12 does force primary market participants to require that 

issuers pledge to disclose future financial and operating information; however, there is little penalty to these same firms if issuers 

do not honor those pledges. The issuers themselves rarely suffer by 

letting disclosure languish. Further, firms trading bonds in the secondary market have little effective responsibility to ensure that the 

bonds being placed in customer accounts (and thus recommended) 

are actually in compliance with issuers’ primary market promises. 

MMA has elsewhere detailed why we believe issuers fail to disclose 

as promised, but our assessment that they do fail, and often, is a 

direct product of our experience analyzing credits in both primary 

and secondary market trades. 

Recommendation: Substantive disclosure improvements do not 

require an end to the Tower Amendment, which bars the Federal 
329 

Government from regulating State and local issuers. The loss of 

Tower would needlessly compromise State autonomy and open the 

door to incremental Federal intervention in State and local affairs. 

Instead, we advocate a market-based solution: 

1. Congress should position a single entity as arbiter to determine whether or not each issuer is in compliance with their 

stated disclosure requirements. This arbiter would likely need 

to be physically associated with the MSRB’s EMMA system 

(or its successor). We recommend that a national issuer group 

control arbiter staffing to reduce potential issuer/investor conflicts in the future. 

2. The arbiter would focus on regular, recurring disclosure items; 

however, regulated market participants should be required to 

pass along instances of non-recurring disclosure violations 

when discovered. 

3. The arbiter would assign two statistics to each municipal 

Cusip. First, those issuers not currently in disclosure compliance would be flagged (red, versus green). Second, the arbiter 

would keep a database to track the number or percent of days 

the issuer was out of compliance over the last ten years. This 

historical statistic could be called the ‘‘disclosure compliance 

score’’ (or, ‘‘DCS’’). 

4. Buyers evaluating primary or secondary market purchases 

could then evaluate the issuer’s current disclosure flag and its 

historical DCS, increasing or reducing their bid accordingly. 

Flags could be easily integrated into customer portfolio statements, mutual fund quarterly statements, trading inventory 

discussions, etc. 

5. In addition, all primary market participants (underwriters, 

bond counsel and other legal staffs, financial and swap advisors, bond insurers, and rating agencies) would be associated 

with an aggregated DCS for all issuers that they’ve helped 

bring to market in the last decade. This firm-by-firm DCS 

reading could give issuers another means to choose among potential intermediaries, while giving investors some insight 

into future disclosure compliance of first time issuers. It could 

also help regulators discover legal or financial firms whose 

issuer clients’ record of disclosure compliance has been poor. 

6. All firms trading municipal bonds, regardless of their status, 

would need to track how many trades, and the volume of par 

traded, that that firm had made with disclosure-flagged 

bonds. Registered firms could be prohibited from trading in 

red-flagged Cusips altogether. Again, this could be very important data for investors evaluating with which firm to invest 

and for firms’ own risk management efforts. 

7. New Federal regulations (e.g., the upcoming revisions to 2a7, any extension of Build America Bond programs, hypothetical SEC rules for financial advisors and dealers, etc.) 

could leverage disclosure flags and DCS scores in addition to 

other factors. 

8. With respect to the MSRB’s EMMA system, we strongly recommend that Congress and/or the SEC ensure that the 
330 

EMMA database include all historical primary and secondary 

market disclosure documents now being archived by the four 

current NRMSRs. This will be a critical factor for investor 

protection once EMMA becomes the sole NRMSR, as, once 

that happens, the current providers will lose their incentive 

(and possibly their financial ability) to adequately maintain 

the databases that have been painstakingly collected over the 

last ten years. The failure to add past databases will also 

allow the MSRB to postpone real disclosure reform on the 

basis that more time is needed to collect information before 

the SRO can determine if lapses have actually occurred. We 

also encourage Congress to require a formal advisory role, 

with respect to EMMA’s organization and delivery of primary 

and secondary market disclosure items, to the National Federation of Municipal Analysts (NFMA)—which represents the 

substantial majority of EMMA’s users (including, we should 

note, both buy-side and sell-side firms). 

9. Finally, we note that we have included no recommendations 

with respect to the content of required secondary market disclosures in 15c2-12. While we believe that what is now being 

disclosed is unsatisfactory in some respects and superfluous in 

others, changes should be a product of broad industry discussion—as they were when rule 15c2-12 was created. We recommend that the MSRB and SEC be required to revisit this 

process to make regular adjustments to 15c2-12 in a fully 

transparent and recurring fashion. 

Q.2. Conflicts of Interest: Concerns about the impact of conflicts of 

interest that are not properly managed have been frequently raised 

in many contexts—regarding accountants, compensation consultants, credit rating agencies, and others. For example, Mr. Turner 

pointed to the conflict of the board of FINRA including representatives of firms that it regulates. The Millstein Center for Corporate 

Governance and Performance at the Yale School of Management in 

New Haven, CT, on March 2 proposed an industry-wide code of 

professional conduct for proxy services that includes a ban on a 

vote advisor performing consulting work for a company about 

which it provides recommendations. 

In what ways do you see conflicts of interest affecting the integrity of the markets or investor protection? Are there conflicts affecting the securities markets and its participants that Congress 

should seek to limit or prohibit? 

A.2. Witness declined to respond to written questions for the 

record. 

Q.3. Credit Default Swaps: There seems to be a consensus among 

the financial industry, government officials, and industry observers 

that bringing derivative instruments such as credit default swaps 

under increased regulatory oversight would be beneficial to the nation’s economy. Please summarize your recommendations on the 

best way to oversee these instruments. 

A.3. Witness declined to respond to written questions for the 

record. 
331 

Q.4. Corporate Governance—Majority Vote for Directors, Proxy Access, Say on Pay: The Council of Institutional Investors, which represents public, union and corporate pension funds with combined 

assets that exceed $3 trillion, has called for ‘‘meaningful investor 

oversight of management and boards’’ and in a letter dated December 2, 2008, identified several corporate governance provisions that 

‘‘any financial markets regulatory reform legislation [should] include.’’ Please explain your views on the following corporate governance issues: 

1. Requiring a majority shareholder vote for directors to be elected in uncontested elections; 

2. Allowing shareowners the right to submit amendment to 

proxy statements; 

3. Allowing advisory shareowner votes on executive cash compensation plans; 

A.4. Witness declined to respond to written questions for the 

record. 

Q.5. Credit Rating Agencies: Please identify any legislative or regulatory changes you believe are warranted to improve the oversight 

of credit rating agencies. 

In addition, I would like to ask your views on two specific proposals: 

1. The Peterson Institute report on ‘‘Reforming Financial Regulation, Supervision, and Oversight’’ recommended reducing 

conflicts of interest in the major rating agencies by not permitting them to perform consulting activities for the firms 

they rate. 

2. The G30 Report ‘‘Financial Reform; A Framework for Financial Stability’’ recommended that regulators should permit 

users of ratings to hold NRSROs accountable for the quality 

of their work product. Similarly, Professor Coffee recommended creating potential legal liability for recklessness 

when ‘‘reasonable efforts’’ have not been made to verify ‘‘essential facts relied upon by its ratings methodology.’’ 

A.5. In the past year, substantial blame has been placed on the rating agencies for: (1) implicit conflicts of interest in the issuer-pays 

(i.e., banker-pays) system; (2) faulty ratings; and (3) the facilitation 

of regulators’ and the financial industry’s over-reliance on ratings 

generally. We believe all these points are well made; however, the 

SEC has already taken positive strides by bolstering the regulation 

of rating agency performance. We do not believe that incremental 

regulation of the rating agencies themselves, beyond these new 

rules, will substantially benefit investor protection. Rather, we encourage Congress to focus on changing regulations that deal with 

how regulators and investors use ratings. 

1. The issuer-pays system cannot be abandoned as, in particular 

in the municipal bond market, there would reasonably be insufficient investor demand to pay for, and consistently maintain, a rating on each and every bond. Were rating agencies 

no longer able to bill issuers for ratings, the number and quality of ratings available would likely contract, increasing the 
332 

informational advantage of dealers and large institutional investors versus individuals and small investors. 

2. Still, any issuer-pays system has obvious potential conflicts of 

interest, and our firm has long advised our subscribers to 

treat rating agency ratings as sales material and consider the 

rating agencies to be effectively part of bond selling groups. 

We believe this more adversarial framework should be employed when including ratings or rating requirements in any 

regulatory documents in the future. 

3. To this point, we believe that Congress should create a set of 

rating definitions (which would speak to investors’ expected 

loss—meaning a combined measure of probability of default 

and loss if a default were to occur) and require that ratings 

adhere to these definitions if they are to be used with respect 

to any Federal regulations (for example, Rule 2a-7). In other 

words, the rating agencies should be able to promulgate and 

sell ratings under any scheme of their choosing, but those ratings could only be used by issuers and investors for compliance with Federal regulations if the rating scale’s definitions 

match those explicitly defined by Congress. This addresses 

what we see as an enormous current problem in that regulations include reference to ratings, but the rating agencies are 

free to define those ratings to their best judgment. Thus the 

problem in the municipal industry where municipal ratings 

reside on a more conservative rating scale than do corporate 

bonds (AAA corporate bonds have defaulted at 10x the rate of 

BBB municipals) but Federal regulations, such as money market fund eligibility rules, use identical rating benchmarks for 

both. Similarly, both commercial mortgage backed securities 

and the US Treasury can be rated AAA but there are obvious 

differences in the rating agencies’ assumptions about the 

meaning behind those ratings. The new SEC rules will greatly 

help that entity monitor the rating agencies’ success in plotting individual ratings along specified, expected-loss-based 

rating scales. 

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds Association testified before the House Subcommittee on Capital Markets 

and said: ‘‘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.’’ MFA supported the creation or designation of a ‘‘single 

central systemic risk regulator’’ that (1) has ‘‘the authority to request and receive, on a confidential basis, from those entities that 

it determines . . . 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,’’ (2) has 

a mandate of protection of the financial system, but not investor 

protection or market integrity and (3) has the authority to ensure 

that a failing market participant does not pose a risk to the entire 

financial system. 

Do you agree with MFA’s position? Do you feel there should be 

regulation of hedge funds along these lines or otherwise? 
333 

A.6. Witness declined to respond to written questions for the 

record. 

Q.7. Self-Regulatory Organizations: How do you feel the self-regulatory securities organizations have performed during the current 

financial crisis? Are there changes that should be made to the selfregulatory organizations to improve their performance? Do you feel 

there is still validity in maintaining the self-regulatory structure or 

that some powers should be moved to the SEC or elsewhere? 

A.7. The current system of SROs has failed municipal investors 

during the current financial crisis, noting: 

1. The MSRB and FINRA have been almost entirely reactive to 

developing crises. MSRB did not issue comments on the collapse of the Auction Rate Securities (ARS) market until February 19, more than a month after the failure of most ARS 

auctions. Instead, the MSRB should have had a more thorough understanding of the ARS product’s almost complete dependency on the: (1) ratings of the bond insurers; and (2) balance sheets of dealer banks. MSRB should have begun an aggressive investor education program starting in August 2007 

and should have provided clear guidance to dealer firms over 

their management of failed auctions. 

2. The MSRB has chosen to pursue derivatives regulation after 

substantial pain has already been felt by the industry. Further, the MSRB’s plan to regulate swap and financial advisors, while likely to the benefit of the industry, would have 

done little to arrest many of the problems actually felt by municipal issuers. For example, widespread derivative problems 

in Tennessee have emanated from derivative sales by Morgan 

Keegan (a broker/dealer already regulated by MSRB). There 

are several other similar instances (in Wisconsin and Pennsylvania and Alabama) where it has been regulated firms’ derivative sales practices, and not failings of unregulated swap advisors, that ultimately created problems for issuers and ultimately individual investors. 

3. Claiming lack of resources, FINRA has been unable to 

proactively pursue (or, investigate without a specific customer 

complaint to guide their actions) clear evidence of broad market manipulation. We believe that FINRA’s funding for 

proactive regulation is minimized by design, as their focus on 

specific, trade-by-trade pricing violations limits their potential 

influence on systemic market characteristics such as how 

bonds are valued and how bonds are distributed. 

4. Indeed, MSRB’s history of avoiding the pursuit of better 

transparency in the municipal market has exaggerated dealer 

banks’ informational advantage versus their customers and 

individual investors. Specifically we note how better information on issuers’ rate and counterparty exposure via derivatives 

and interest rate swaps could have helped both individual investors and the issuers themselves manage their particular 

exposure. 

5. The MSRB has not aggressively pursued widespread instances 

of current disclosure failure in the municipal industry. While 
334 

the MSRB has worked to create and rollout their EMMA system that may bring an ultimate improvement to disclosure, 

they have avoided taking any opinion or making any immediate corrective actions to ongoing disclosure problems hurting 

investors today. Further, we believe that the MSRB’s plans to 

rollout EMMA, collect information for a year, and then see if 

disclosure is really a problem reflects an intent to maintain 

dealers’ informational advantage (gained by limiting investors’ 

access to disclosure documents) for as long as possible. 

6. And perhaps most importantly, the MSRB has largely failed 

to educate and keep informed the macro regulators and US 

legislature on issues involving municipal bonds. We believe 

this is a fundamental problem with SROs in that, fearing 

more formal regulation, they attempt to shield specific details 

and developments from broad review; thus our phrase, ‘‘municipals are a backwater by design.’’ MMA was first contacted 

by regulators (in the summer of 2007) and since that time we 

have maintained a highly active dialogue with both Congressional staffs and macro regulators. We have been shocked at 

the lack of understanding of even the rudiments of our industry, the flows of capital and data, the important players and 

pressures. In fact, we believe that, had the MSRB more actively attempted to educate Washington policymakers prior to 

the current crisis, the Federal response could have been more 

rapid and better informed. 

Given the events of the past 18 months, I believe that regulation 

must be integrated and centralized. Because of these failures, it 

would be prudent to either move the MSRB into the SEC—or, at 

a minimum certain changes must be made to the MSRB structure. 

If Congress deems it necessary that a SRO is an inappropriate 

model for regulation of the municipal industry, the following should 

take place: 

1. Create a Division of Municipal Securities that would report directly to the Chairman of the SEC. Move the current Office 

of Municipal Securities out of the Division of Trading and 

Markets into this new Division. Move all MSRB staff and its 

current funding structure into this new Division. The municipal industry is such a unique market and functions in such 

a different way from other markets that it should be separate 

from other markets. In creating a new division, the industry 

would benefit from specialized staff and researchers as well as 

having a direct line of communication with the office of the 

Chairman. 

2. The MSRB staff must be bolstered with more seasoned municipal experts and create specific offices within the Municipal division focused on: secondary markets, underwriting, derivatives, accounting, disclosure, ratings, and bond insurance and 

tax issues. Compensation should and can be competitive to ensure the best staff possible. Under current MSRB funding 

structure, in 2008 the MSRB received $22.1 million in revenue and in 2007 it relieved $21.4 million in revenue. The 

Board derives revenue from primary and secondary trans-
335 

actions that market participants pay. Detailed financial statements are available on the Board’s Web site. 

3. Similar to our conclusions above in the disclosure responses, 

substantive regularly improvements do not require an end to 

the Tower Amendment, which bars the Federal Government 

from regulating State and local issuers. The loss of Tower 

would needlessly compromise State autonomy and open the 

door to incremental Federal intervention in State and local affairs. Instead, we advocate a market-based solution. 

4. Create a Municipal Securities Rulemaking Advisory Board 

(MSRAB) that will be made up of 15 ‘‘at large’’ current and 

retired market participants. The MSRAB will produce a report 

to Congress and the Treasury Dept. annually on new trends 

in the market and potential regulatory shortcomings. The 

MSRAB should have continual communication with the Division of Municipals Securities. 

5. Create a SEC-FINRA enforcement coalition council whereby 

information is shared in a fluid basis on future enforcement 

actions. 

6. Create regional SEC municipal offices under the Division to 

monitor regional activities on closer basis. The municipals 

market, more than any other market in the U.S., is dominated 

by local politics and is quite fragmented. Having staff on the 

ground in every major region is essential to productive regulation and timely enforcement. 

On the other hand, we do note that there remains strong industry and perhaps even issuer support for the current SRO structure; 

MMA has received multiple comments to this effect since our Senate testimony. Thus, while we do believe that integrating the 

MSRB’s components into an independent regulator is the better 

course of action, Congress may instead choose to preserve the current MSRB as an SRO structure. In preserving the SRO, we recommend Congress do the following: 

1. Replace the current, dealer-centric MSRB board with representative members who provide independent and objective 

insight into the various aspects of the purpose of the municipal industry—the efficient and effective raising of capital for 

municipal entities. 

2. Require that there be frequent and regular communication between the municipal regulatory network (MSRB, FINRA, 

Treasury, SEC, and the Federal Reserve), perhaps in the form 

of weekly or monthly committee meetings. The SEC should be 

given full access to minutes of any discussions; these minutes 

should be made publicly available to the extent possible. A 

semi-annual report to Congress on the status of the industry 

should be required. 

3. Regulate and collect real-time information on municipal derivatives including interest rate swaps and credit default 

swaps. All derivatives information should be made publicly 

available, illustrating, among other points: counterparty exposure, termination and cost exposure under absolute worst case 

scenarios, and price volatility assumptions. 
336 

There is no question in my mind that better regulation comes 

from participants who understand the motivations of the participants and the environment in which market participants work on 

a daily basis. The theoretical concept or asset of the SRO regulatory concept is based on having knowledgeable people involved in 

the process—not bureaucrats or those susceptible to political pressures. However, as has been readily apparent, an SRO is inhibited 

by the time an active market participant can commit to a volunteer 

position (regardless of how well intended the individual) and the 

challenge of the participant to act for the industry’s best interest 

(i.e., altruistically) when it may run contrary to the interests of its 

employer and one’s own employment viability. 

Specific to the municipal industry, the current composition of the 

Board, with 10 of 15 spots allotted to security dealers, does not provide for a balanced perspective of the industry and participants. 

The board must be broad, independent and structure/composition 

must be adaptable and flexible in its construct to anticipate future 

industry change. A balance of board members from different constituencies of the market and who are predominantly, not necessarily exclusively, retired from active industry involvement would 

more likely provide independent counsel, industry practical knowledge and a more comprehensive overview being removed from dayto-day industry responsibilities. 

Q.8. Structure of the SEC: Please share your views as to whether 

you feel that the current responsibilities and structure of the SEC 

should be changed. 

Please comment on the following specific proposals: 

1. Giving some of the SEC’s duties to a systemic risk regulator 

or to a financial services consumer protection agency; 

2. Combining the SEC into a larger ‘‘prudential’’ financial services regulator; 

3. Adding another Federal regulators’ or self-regulatory organizations’ powers or duties to the SEC. 

A.8. Witness declined to respond to written questions for the 

record. 

Q.9. SEC Staffing, Funding, and Management: The SEC has a 

staff of about 3,500 full-time employees and a budget of $900 million. It has regulatory responsibilities with respect to approximately: 12,000 public companies whose securities are registered 

with it; 11,300 investment advisers; 950 mutual fund complexes; 

5,500 broker-dealers (including 173,000 branch offices and 665,000 

registered representatives); 600 transfer agents, 11 exchanges; 5 

clearing agencies; 10 nationally recognized statistical rating organizations; SROs such as the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board and the Public 

Company Accounting Oversight Board. 

To perform its mission effectively, do you feel that the SEC is appropriately staffed? funded? managed? How would you suggest that 

the Congress could improve the effectiveness of the SEC? 

A.9. The SEC needs a mechanism to collect market information 

and input from participants so as to understand the impact both 

short and long-term regarding policy actions. My limited experience 
337 

with the municipal division of the SEC is that there is an interest 

to understand and learn. However, the entrenched mechanisms 

that have historically inhibited timely action and response to consumer needs or systemic risks has reduced the initiative and innovation among a long standing staff. There would appear to be a 

need for new structure in order to enliven the current talent pool. 

The MSRB funding structure is very profitable and moving the 

MSRB into a new SEC division should pay for itself. MSRB annual 

financial statements are available on its Web site. 

Q.10. MSRB’s Data System: Please explain in detail why the Congress should consider ‘‘End[ing] the MSRB as an SRO’’ and 

‘‘Integrat[ing] the MSRB formally and directly into a larger entity, 

possibly the Securities Exchange Commission, Treasury or Federal 

Reserve’’ as you suggest in your written testimony. Also, what is 

your evaluation of the impact of the MSRB’s new EMMA data system on investors and dealers? 

A.10. In my oral and written testimony I did advocate for the end 

of the SRO era with specific reference to the MSRB. My advocacy 

comes from the direct experience of seeing: 

1. Volunteer board members deferring decision-making and becoming over-reliant on staff; 

2. Volunteer dealer members slowing down processes to inhibit 

the creation of regulation that would inhibit current profitmaking enterprises; 

3. Anti-regulation bias among dealer community inhibited innovative action; 

4. That dealer participants, especially in larger firms, were compromised in advocating regulatory changes that might establish regulatory precedent which could potentially reduce their 

employer’s near-term profitability because their own employment could be at risk for taking such action; 

5. An absence of representation of the wide range of participants 

in the municipal industry has historically inhibited the gathering of pertinent information for appropriate regulation that 

would create better and more informed rules and policies. 

The current structure of the SRO has resulted in the pockets of 

regulatory opacity not being addressed. 

Had the MSRB been integrated into a larger entity in a coordinated manner, the risks being promulgated in the municipal industry might have been recognized sooner—not only to avert the chaos 

which ensued over the past 18 months but also might have raised 

awareness that similar excessive risks were occurring in other markets which could have prompted earlier and more prophylactic regulatory action to mitigate the systemic risks which ensued. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM THOMAS DOE 

Q.1. Do you all agree with Federal Reserve Board Chairman 

Bernanke’s remarks today about the four key elements that should 

guide regulatory reform? 
338 

First, we must address the problem of financial institutions that are deemed too 

big—or perhaps too interconnected—to fail. Second, we must strengthen what 

I will call the financial infrastructure—the systems, rules, and conventions that 

govern trading, payment, clearing, and settlement in financial markets—to ensure that it will perform well under stress. Third, we should review regulatory 

policies and accounting rules to ensure that they do not induce excessive 

procyclicality—that is, do not overly magnify the ups and downs in the financial 

system and the economy. Finally, we should consider whether the creation of 

an authority specifically charged with monitoring and addressing systemic risks 

would help protect the system from financial crises like the one we are currently experiencing. 

Would a merger or rationalization of the roles of the SEC and 

CFTC be a valuable reform, and how should that be accomplished? 

How is it that AIG was able to take such large positions that it 

became a threat to the entire financial system? Was it a failure of 

regulation, a failure of a product, a failure of risk management, or 

some combination? 

How should we update our rules and guidelines to address the 

potential failure of a systematically critical firm? 

A.1. Witness declined to respond to written questions for the 

record. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR DODD 

FROM LYNN E. TURNER 

Q.1. Transparency: Are there additional types of disclosures that 

Congress should require securities market participants to make for 

the benefit of investors and the markets? 

Also, would you recommend more transparency for investors: 

1. By publicly held banks and other financial firms of off-balance 

sheet liabilities or other data? 

2. By credit rating agencies of their ratings methodologies or 

other matters? 

3. By municipal issuers of their periodic financial statements or 

other data? 

4. By publicly held banks, securities firms and GSEs of their risk 

management policies and practices, with specificity and timeliness? 

A.1. Witness declined to respond to written questions for the 

record. 

Q.2. Conflicts of Interest: Concerns about the impact of conflicts of 

interest that are not properly managed have been frequently raised 

in many contexts—regarding accountants, compensation consultants, credit rating agencies, and others. For example, Mr. Turner 

pointed to the conflict of the board of FINRA including representatives of firms that it regulates. The Millstein Center for Corporate 

Governance and Performance at the Yale School of Management in 

New Haven, Connecticut on March 2 proposed an industry-wide 

code of professional conduct for proxy services that includes a ban 

on a vote advisor performing consulting work for a company about 

which it provides recommendations. 

In what ways do you see conflicts of interest affecting the integrity of the markets or investor protection? Are there conflicts affect-
339 

ing the securities markets and its participants that Congress 

should seek to limit or prohibit? 

A.2. Witness declined to respond to written questions for the 

record. 

Q.3. Credit Default Swaps: There seems to be a consensus among 

the financial industry, government officials, and industry observers 

that bringing derivative instruments such as credit default swaps 

under increased regulatory oversight would be beneficial to the nation’s economy. Please summarize your recommendations on the 

best way to oversee these instruments. 

A.3. Witness declined to respond to written questions for the 

record. 

Q.4. Corporate Governance—Majority Vote for Directors, Proxy Access, Say on Pay: The Council of Institutional Investors, which represents public, union and corporate pension funds with combined 

assets that exceed $3 trillion, has called for ‘‘meaningful investor 

oversight of management and boards’’ and in a letter dated December 2, 2008, identified several corporate governance provisions that 

‘‘any financial markets regulatory reform legislation [should] include.’’ Please explain your views on the following corporate governance issues: 

1. Requiring a majority shareholder vote for directors to be elected in uncontested elections; 

2. Allowing shareowners the right to submit amendment to 

proxy statements; 

3. Allowing advisory shareowner votes on executive cash compensation plans. 

A.4. Witness declined to respond to written questions for the 

record. 

Q.5. Credit Rating Agencies: Please identify any legislative or regulatory changes you believe are warranted to improve the oversight 

of credit rating agencies. 

In addition, I would like to ask your views on two specific proposals: 

1. The Peterson Institute report on ‘‘Reforming Financial Regulation, Supervision, and Oversight’’ recommended reducing 

conflicts of interest in the major rating agencies by not permitting them to perform consulting activities for the firms 

they rate. 

2. The G30 Report ‘‘Financial Reform; A Framework for Financial Stability’’ recommended that regulators should permit 

users of ratings to hold NRSROs accountable for the quality 

of their work product. Similarly, Professor Coffee recommended creating potential legal liability for recklessness 

when ‘‘reasonable efforts’’ have not been made to verify ‘‘essential facts relied upon by its ratings methodology.’’ 

A.5. Witness declined to respond to written questions for the 

record. 

Q.6. Hedge Funds: On March 5, 2009, the Managed Funds Association testified before the House Subcommittee on Capital Markets 
340 

and said: ‘‘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.’’ MFA supported the creation or designation of a ‘‘single 

central systemic risk regulator’’ that (1) has ‘‘the authority to request and receive, on a confidential basis, from those entities that 

it determines . . . 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,’’ (2) has 

a mandate of protection of the financial system, but not investor 

protection or market integrity and (3) has the authority to ensure 

that a failing market participant does not pose a risk to the entire 

financial system. 

Do you agree with MFA’s position? Do you feel there should be 

regulation of hedge funds along these lines or otherwise? 

A.6. Witness declined to respond to written questions for the 

record. 

Q.7. Self-Regulatory Organizations: How do you feel the self-regulatory securities organizations have performed during the current 

financial crisis? Are there changes that should be made to the selfregulatory organizations to improve their performance? Do you feel 

there is still validity in maintaining the self-regulatory structure or 

that some powers should be moved to the SEC or elsewhere? 

A.7. Witness declined to respond to written questions for the 

record. 

Q.8. Structure of the SEC: Please share your views as to whether 

you feel that the current responsibilities and structure of the SEC 

should be changed. 

Please comment on the following specific proposals: 

1. Giving some of the SEC’s duties to a systemic risk regulator 

or to a financial services consumer protection agency; 

2. Combining the SEC into a larger ‘‘prudential’’ financial services regulator; 

3. Adding another Federal regulators’ or self-regulatory organizations’ powers or duties to the SEC. 

A.8. Witness declined to respond to written questions for the 

record. 

Q.9. SEC Staffing, Funding, and Management: The SEC has a 

staff of about 3,500 full-time employees and a budget of $900 million. It has regulatory responsibilities with respect to approximately: 12,000 public companies whose securities are registered 

with it; 11,300 investment advisers; 950 mutual fund complexes; 

5,500 broker-dealers (including 173,000 branch offices and 665,000 

registered representatives); 600 transfer agents, 11 exchanges; 5 

clearing agencies; 10 nationally recognized statistical rating organizations; SROs such as the Financial Industry Regulatory Authority, the Municipal Securities Rulemaking Board and the Public 

Company Accounting Oversight Board. 

To perform its mission effectively, do you feel that the SEC is appropriately staffed? funded? managed? How would you suggest that 

the Congress could improve the effectiveness of the SEC? 
341 

A.9. Witness declined to respond to written questions for the 

record. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM LYNN E. TURNER 

Q.1. Do you all agree with Federal Reserve Board Chairman 

Bernanke’s remarks today about the four key elements that should 

guide regulatory reform? 

First, we must address the problem of financial institutions that are deemed too 

big—or perhaps too interconnected—to fail. Second, we must strengthen what 

I will call the financial infrastructure—the systems, rules, and conventions that 

govern trading, payment, clearing, and settlement in financial markets—to ensure that it will perform well under stress. Third, we should review regulatory 

policies and accounting rules to ensure that they do not induce excessive 

procyclicality—that is, do not overly magnify the ups and downs in the financial 

system and the economy. Finally, we should consider whether the creation of 

an authority specifically charged with monitoring and addressing systemic risks 

would help protect the system from financial crises like the one we are currently experiencing. 

Would a merger or rationalization of the roles of the SEC and 

CFTC be a valuable reform, and how should that be accomplished? 

How is it that AIG was able to take such large positions that it 

became a threat to the entire financial system? Was it a failure of 

regulation, a failure of a product, a failure of risk management, or 

some combination? 

How should we update our rules and guidelines to address the 

potential failure of a systematically critical firm? 

A.1. Witness declined to respond to written questions for the 

record. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR VITTER 

FROM LYNN E. TURNER 

Q.1. Are you concerned that too much reliance on investor protection through private right of action against the credit ratings agencies will dramatically increase both the number of law suits the 

companies will have to deal with as well as their cost of doing business? Have you thought about alternative ways to ensure adequate 

investor protections that will not result in driving capital from the 

U.S. in the same way that the fear of litigation and costs created 

by Sarbanes-Oxley has resulted in a decline in new listings in 

American capital markets? 

A.1. Witness declined to respond to written questions for the 

record.