The SEC’s Fate Under Obama Administration

By now you’ve read thousands of articles speculating on what an Obama Administration will mean for the world, for America, and for your business. These pundits (including us) have viewed President-elect Obama as the creative architect, and everyone is trying to sneak a peek at his plans.

We’d like to suggest, however, that after you’re done gawking at the fancy new governmental policies and programs—the trillion-dollar stimulus package, the plans to green our energy usage, and so forth—you should pay attention to the boring stuff as well. You want to be sure that what engineers call “the mechanicals”—the heating, electrical, plumbing—actually work, and work well. More than anything else, they may tell the tale of the new administration over time. They will determine the quality of execution of the new programs, which will have as much to do with the Obama Administration’s success as the philosophy behind them.

Enforcement is one of those mechanicals. No matter what laws and regulations the Obama Administration and Congress enact, they will rely on appropriate enforcement to catch lawbreakers and to deter those who might consider wrongdoing, as well as on the consent of the willing. So we suggest you consider the fate of the Securities and Exchange Commission.

For generations that agency was the focal point of American capital market regulation; it has become a second-class citizen under the Bush Administration. Almost every day, Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernancke are front-and-center, providing monetary interventions, privatizations, TARP updates, and other extraordinary federal responses to the financial crisis. By contrast, SEC Chairman Christopher Cox might as well have his picture on the side of a milk carton, under the caption “missing.”

Enforcement has been invisible in the administration’s response to the financial crisis. Think about it: Can you name a single notable SEC enforcement action related to the crisis? Yet this is an administration so worried about market manipulation and its effect on our financial system that it temporarily suspended all short selling, disrupting legitimate trades as well as potentially illegal ones. Has there been no market manipulation, no improper use of credit default swaps or other instruments? We suppose it’s possible that nobody has acted corruptly amid all this market volatility, but that’s pretty hard to believe.

The SEC has been further marginalized by effectively handing off regulation of the financial sector to the Federal Reserve and Treasury. Regulation of financial institutions has always been fractured, with the SEC overseeing the investment banks, the Fed overseeing chartered commercial banks, and even the New York state insurance commissioner overseeing titans such as American International Group. This hodge-podge of regulators and enforcers continues to exist years after deregulation effectively blurred the lines between investment banks, commercial banks, insurance companies, and consumer finance companies.

Now, however, the Emergency Economic Stabilization Act, combined with practically every major investment bank on Wall Street converting into a commercial bank, means that even more regulation of the financial system has been removed from the SEC’s hands and placed into those of the Federal Reserve or the Treasury Department.

Cox further eroded SEC authority by ceding future regulation of credit default swaps to the Fed. And his vision to allow periodic reporting according to International Financial Reporting Standards rather than U.S. Generally Accepted Accounting Principles, no matter how well intentioned or even beneficial, will further erode the SEC’s power over time. And as if that weren’t enough, Cox’s SEC managed to polarize and enrage both the investor and issuer communities with its ham-handed effort to address investor access to the proxy statement, diminishing the agency’s reputation still more.

The SEC, this lynchpin of enforcing effective capital markets, is in dire need of repair or outright redesign.

The SEC 2.0

The question then becomes not only what new securities laws will look like, but also how they will be enforced. With the SEC emasculated, how will President-elect Obama fix the federal government’s capital market enforcement ability? There are at least three options, which may be combined or partially implemented.

First, Obama can choose repair: Keep the existing structure and simply appoint a new SEC chairman with the mandate to restore the luster of the SEC. A crusader with a presidential mandate could turn around the SEC’s slide.

Second, Obama can tinker with a minor redesign, by focusing only on the financial sector. In that case, it’s likely that some of the enforcement personnel at the SEC who have dealt with the investment banks over the years will be transferred to the Fed, to maintain domain expertise within the appropriate regulator. Such a course of action would continue the current reality, but wouldn’t necessarily doom the SEC to further erosion.

Third, the President-elect can redesign enforcement entirely by trying to rationalize the fractured enforcement landscape we have today. That would mean combining all or parts of the SEC, Commodity Futures Trading Commission, and possibly even the Federal Reserve into a true capital market regulator, somewhat like the Financial Services Authority in Britain. Parochial interests have halted the creation of such a unified regulator-enforcer in the past, but the unprecedented failure of the financial institution regulatory regime may be enough to overcome political bickering this time. Moreover, restructuring would reduce administrative overhead at a time when the new administration will need to find every penny it can to pay for the various stimuli and other policy initiatives.

The SEC, this lynchpin of enforcing effective capital markets, is in dire need of repair or outright redesign.

If enforcement is one part of the mechanicals that needs fixing, communication and governance are others. We’ve detailed the obvious potential policy changes in the past: shareholder advisory votes on executive pay, some form of proxy access, and an ending to broker votes in director elections. But we might also see a new market response outside the government’s territory that could spur critical changes to the market’s plumbing.

Consider how proxy votes are actually counted and how investors and corporations communicate. Serial entrepreneur Arthur Rosenzweig is now challenging the dominance of Broadridge, the ADP spinout that is the de facto monopoly provider of proxy voting services to U.S. corporations. The proxy voting business naturally lends itself to economies of scale, so Broadridge starts with a huge advantage. But Rosenzweig is no stranger to challenging competitors with installed advantages; in the 1990s, his Proxy Monitor challenged Institutional Shareholder Services, before effectively taking control of his larger rival in 2001.

For years, the proxy voting system in the United States has been driven by two complaints. First, institutional investors fretted that they had no feedback loop; they simply could not verify that their votes were counted. Corporations, meanwhile, complained that a combination of regulation and technological limitations curtailed their ability to know the identity of their shareholders on a timely basis or to communicate effectively with them.

Rosenzweig’s Mediant Communications promises to give institutional investors an audit trail to prove that their votes were cast. Look for that feature to become standard within a year or two no matter which provider wins the battle.

Also, with Mediant attacking and Broadridge mustering a vigorous defense, expect corporations to mount a push for SEC action on their ability to know who their owners are. At issue are the Objecting Beneficial Owners rules, which limit access to ownership records. Politically, efforts to reveal investor identities have more traction than ever. Regulators and legislators are concerned that some hedge funds and others use derivative transactions to evade disclosure rules and disguise their ownership.

Now, we’re not saying folks should ignore the shiny new policies the Obama Administration is likely to unveil. Do look at them, closely. We’re anxious to see them as well. We just want to remind you to know how the plumbing works, not just what the new bathroom looks like. Because a bathroom whose plumbing fails is a problem, no matter how much shiny new marble has been installed.