Barney Frank, SEC’s Aguilar on Financial Crisis

As regulators at the Securities and Exchange Commission seek to understand the root causes of the financial crisis, legislative leaders in Congress are striving to enact new laws intended to prevent it from happening again.

Those were the messages from SEC Commissioner Luis Aguilar and U.S. Rep. Barney Frank, delivered in keynote speeches at Compliance Week 2010 last week in Washington, D.C. While their visions differed over the logistical details of reform, both men said that from a regulatory and legislative perspective, far more must be done to deter reckless behavior in the financial markets. Each also pointed to the mysterious “flash crash” that struck Wall Street on May 6 as evidence that the threat remains.

Aguilar, speaking on May 24, focused on the challenges of overseeing “seamlessly connected” capital markets, while regulators’ responsibilities “are piecemeal.”

“We still do not know why the markets malfunctioned as they did,” he said. “If we truly seek to understand what happened on May 6 and how to prevent it from happening again, our inquiry cannot focus solely on the exchange-listed markets.”

Frank said the flash crash underscores how a strong regulatory regime “very much” depends on global coordination. At the very least, he said, stock exchanges should have a policy of coordinated shutdowns during times of stress—something they did not have, or do, on May 6.

Frank, who chairs the House Financial Services Committee, also made news with his predictions of what will be in the final regulatory reform legislation Congress is likely to pass this month. The House passed a reform bill in December and the Senate did so in May, but the two versions do have key differences about oversight of derivatives, compliance with the Sarbanes-Oxley Act for small public companies, funding for the SEC, and several other items.

U.S. Rep. Barney Frank, addressing the crowd at Compliance Week 2010.

Most notably, Frank poured cold water on a provision in the Senate bill to force commercial banks to spin off their investment banking operations. He said he will seek to strip that language out of the final bill, instead favoring the so-called “Volcker Rule,” which would only order commercial banks not to trade using their own capital and prohibit them from certain high-risk derivative instruments.

Frank did stress, however, that the largely unregulated derivatives market will soon see its end. After passage of the financial reform bill, “there will be no entity in America that does not have to report financial transactions to a regulator,” he said. “No derivate contract will be allowed unless it is reported to the appropriate entity.”

Frank also predicted that Congress’s final regulatory legislation will include an exemption from Section 404(b) of the Sarbanes-Oxley Act for non-accelerated filers. That provision requires companies to have their internal controls over financial reporting reviewed by outside auditors, but the SEC has exempted small filers from compliance annually for the last six years.

The House bill contains language to make that exemption permanent; the Senate does not. Frank admitted that he personally is opposed to granting the exemption, but he doesn’t have the votes to stop it. “I believe it will be in the final bill,” he said.

Expanding Enforcement

Aguilar discussed regulatory enforcement at length. He stressed that the concept of sophisticated investors—“which underlies many regulatory gaps”—must be re-examined, to see how reckless behavior in that group affects other investors in the capital markets. The idea that institutional investors can operate without the usual norms of transparency and oversight is faulty, Aguilar said; in reality, pension funds, hedge finds, and other like entities need “complete and honest disclosure.”

“The more we try to slice and dice which investors receive what protections, the more all investors, the integrity of the capital markets, and all the American public will bare the costs,” he said.

“If we truly seek to understand what happened on May 6 and how to prevent it from happening again, our inquiry cannot focus solely on the exchange listed markets.”

—Luis Aguilar,

Commissioner,

Securities & Exchange Commission

Aguilar also addressed the subject of corporate penalties for securities violations, and minced no words: “We need to actively sanction both corporations and individuals.” He argued that since corporate misconduct is orchestrated by individual people, both the company and the responsible person should pay the price to make defrauded investors whole. “For money to come out of shareholders’ pockets, it first has to be in shareholders’ pockets,” he said, and floated the idea that the bonuses of wrongdoers should be reduced by the amount of the penalty.

Circling back to the financial crisis as an example of how unregulated or under-regulated behavior can cause disaster, Aguilar said, “It’s clear that the responsibility is shared among Wall Street participants legislators, and, yes, regulators.” In particular, he said, “there can be little doubt that the biggest and most active market participants did, in fact, contribute greatly to the process,” and yet those participants accept “almost no responsibility in their role.”

Aguilar did also give his usual plug for more SEC resources, both to investigate the causes of the financial crisis and to crack down on fraud. He called for the SEC to fund its own budget through registrant fees, fines, and other revenue sources, rather than the current system of an annual appropriation from Congress.

Legislation to do that is in the Senate reform bill, but not in the House version—and Frank also warned that the House is not particularly eager to allow it. He said he is hoping for some sort of hybrid model, where the SEC can secure self-funding, “but in a way where the [House] Appropriations Committee can stay involved.”

Regulatory Reach

Aguilar admitted that the SEC still has a long road ahead to understanding the financial crisis and determining who it should police to prevent another meltdown. He partly blamed the various waves of deregulation in the last 20 years, which brought along stagnant or reduced budgets with them.

SEC Commissioner Luis Aguilar, right, talks with Compliance Week editor Matt Kelly.

“More information about how the markets actually work is shockingly difficult to obtain,” he said. “This is disappointing, but it should not be a surprise.”

Frank said he saw the picture in a slightly different view. “I don’t think our problem is de-regulation; our problem is non-regulation,” he said. “Never have there been rules for securitization or credit defaults swaps. It’s a new phenomenon.”

Aguilar also said that serious questions exist, from both market participants and regulators, regarding the algorithms that so-called “quant” investors use for automated trading. Unforeseen quirks in automated trading have emerged as one prime suspect of the May 6 flash crash, although nobody has pinpointed their exact role. “When not even the regulators understand how the markets are regulated, something is seriously wrong with the regulatory scheme,” Aguilar said.

One solution Aguilar proposed: for the SEC to have the ability to conduct surveillance of market behavior in real time. “Real-time market participation is necessary for effective, regulatory fact-finding, oversight, and enforcement,” he said.

Along those lines, two days after Aguilar’s speech, the SEC proposed a new rule requiring stock exchanges to establish a “consolidated audit trail system” that would let regulators track information related to trading orders received and executed across the securities markets. SEC action on that proposal is likely later this summer.