U.S. securities markets and the Maginot Line

Check out the latest speech from SEC chairman Christopher Cox at the 34th Annual Securities Regulation Institute in Coronado, California. (See Re-Thinking Regulation in the Era of Global Securities Markets.) The topic is the cross-border integration of stock markets, and Cox warns that if the U.S. isn't careful, it's securities laws risk becoming like the French Maginot Line. (As you probably know, the Maginot Line was a system of static fortifications that ran along the Franco-German border and built during the 1930s to keep the Germans from invading France. It was premised on the idea that the next war would be like the last -- i.e., a defense-dominated situation like WWI. Instead, technological and tactical innovations allowed the Germans to do an end-run around the Maginot Line and move deep into France before the French -- who actually had more troops and more modern equipment -- were able to respond.)

So, basically, Cox is warning that if the SEC fails to adapt, U.S. securities regulations risk becoming as potent, innovative and competent as the French military. Ouch!

Without a doubt, our regulatory defenses proved very effective in maintaining healthy markets in the 20th century. The world-beating success of America's capital markets is a testament to that. For most of the last 74 years, our ability to police our markets and maintain investor confidence in their integrity has been premised on requiring both domestic and foreign market participants that operate in the U.S. to register with the SEC — and for the most part, to follow the same rules. That approach has followed from our concern that the alternative, permitting foreign market participants to operate in the U.S. without direct SEC oversight, would threaten the integrity of our nation's capital markets.

But while this approach served us well in the past, when the world's capital markets were separated not just by oceans but by the preference and habits of most investors, the world is a far different place today. And so we have to ask ourselves: have the basic assumptions on which we've built these regulations changed?
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I'm convinced that the way to surmount these new challenges posed by technology is to harness the power of that same technology. We've got to recognize that to catch a global network of market crooks, it will take a global network of securities cops.

That means that our success will be measured not by the degree to which we close off other marketplaces from our own, but rather by the extent to which we more closely integrate our regulatory efforts as our markets themselves become more closely connected.

Every regulator has an obligation to the investors and issuers within its borders to protect them from fraud perpetrated within those borders. For the SEC, therefore, every other like-minded regulator is our natural ally. We've made great strides in recent years in building ways to share enforcement information with our counterparts in other countries, and to cooperate in doing every other part of our jobs. And as the story of this success has spread, we have found new friends and allies sharing the same concerns and devoted to the same cause of protecting investors and promoting capital formation.

This process of discovering our mutual interests has led us to realize that some of the old ways of doing things are obsolete. For example, while our historical justification for having issuers, broker-dealers and exchanges to register with the SEC is sound, it may be that by working with like-minded foreign counterparts we can find ways to lower costs and increase opportunities for investors while still maintaining the highest standards of investor protection. In this regard, the Memorandum of Understanding we recently concluded with the College of Euronext Regulators should be an excellent start.

And this brings us to an interesting question. Just what is "like-mindedness"? Will we know it when we see it? I believe the answer to this question is not wholly subjective. In my discussions with our counterpart regulators in other countries, I have found one touchstone in particular that is of overarching importance. It is an acceptance by the regulator that the genius of the market is that individuals are free to investigate their options and make their own decisions. It is an appreciation for the "wisdom of the crowd" that is ultimately the consensus of that market — representing the solution of many minds working on a common problem.

Working with all of the world's regulators who share this belief in the power of markets, we can tap that same principle, so that a multiplicity of jurisdictions — each seeking to develop the best regulatory framework — can likewise investigate their options and make their own decisions about ways to handle regulatory issues within their borders. This is something from which we all can benefit: observing what works, and how the market responds, and learning from what doesn't work.

To give you just one example of what the "wisdom of the crowd" means for securities regulators, consider the global reaction to the Sarbanes-Oxley Act. There has been loud complaint about its costs, even by some in other jurisdictions to whom it does not apply. But one interesting effect of these reforms has been the degree to which they have been copied, in one form or another, in many other major markets.

A lot of interesting ideas here. My question is, is Cox really signally support for radical change to how the SEC operates internationally? Some of the ideas in this speech (regulatory competition, working with "like-minded" foreign regulators, etc.) clearly echo ideas in a recent Harvard International Law Journal article by SEC staffers proposing a "substituted compliance" approach. (See here.)

My second question is, what effect would such a radical change have for the U.S. market? The FT on Friday led with an article on comments by Lehmean Brothers vice-chairman Thomas Russo at the World Economic Forum in Davos, Switzerland where Russo basically said that despite all the sturm-und-drang over New York's falling position in world finance, it is unlikely to ever recover no matter what policies the U.S. enacts. (See NY unable to regain lost business, says top banker.) Russo, however, doesn't seem to be imagining that truly radical change is possible. To carry the Maginot Line analogy even farther (by the way, the guy who thought up that analogy -- brilliant!), in 1940 even the German Army High Command believed the invasion of France would break down into a static war of attrition. Only a radical change in tactics, envisioned by Heinz Guderian and Erich von Manstein, allowed Germany to march into Paris only 6 weeks after the invasion began. If the SEC were to adopt a radical change -- made all the more relevant by the cross-border consolidation of stock exchanges -- New York may still have its day in the sun.

My 2007 Predictions: Does this count?

Not really, I guess. On Dec. 27, just a few hours before I made my New Year's predictions (here), incoming House Financial Services Committee chairman Barney Frank issued this press release criticizing the SEC's December 22 decision to align its executive compensation disclosure rules with existing accounting rules. This new rule, which you can read here (if you a real masochist), replaces the existing SEC rule that says that when companies give executives stock options, these options have to be disclosed at the time of the grant. The new rule follows Financial Accounting Standard 123R (which you can read here, if you are really really really masochistic), so that public companies now only have to disclose the grant as they are exercised (i.e., when the executive actually calls in the grant and the company has to fork over the money to buy the shares).

There is some logic to this new rule, since a grant of stock options is worthless until it is exercised, and they can be exercised at different times. In other words, under the old approach, a company could disclose that it issued a CEO 1000 stock options in one year (not necessarily indicating the price of the stock), and nothing over the next five years, with an annual salary being (for example) $500,000. The disclosure would then look like $500K +1000 stock options in Year 1, then $500K for Years 2 through 6. Under the new rule, the company would have to disclose the stock options, and the fair market value, when the options become exercisable. In other words, if 100 of the 1000 options become exercisable each year, in Year 1, the company would disclose $500K in salary, in Year 2 $500K + 100 stock options at $1000 per share, in Year 3 $500K +100 stock options at $1100 per share, etc. The idea is to give investors an idea about how much the CEO is costing the company each year, and how much the CEO is actually making in each year. Furthermore, this is how companies currently have to account for stock options. (In the past, issuers did not have to expense stock options at all.)

Despite the logic behind the SEC's decision, you could argue that it comes at a bad time. Executive stock options are in the news because of the backdating scandal. Most people don't understand what the issue is about, except that it's bad. Add on top of that the view of some that what investors really want to know about is when the board decides to grant stock options (not necessarily when the come due or when the CEO exercises those options), and it could look like the SEC is making it harder for investors to know how overpaid the CEOs of their companies are. And that, of course, is what Barney Frank is saying.

I am very disappointed with both the substance and the procedure used to reach the SEC’s Christmas Eve decision to loosen reporting requirements for the pay of the top executives of public corporations. It is especially ironic that the SEC would relax the rules regarding stock options at precisely the time that widespread abuses of the practice are coming to light. The problem of executive pay that is both greatly excessive and deliberately obscured is a grave one. I had been encouraged when the SEC recognized this problem in its initial proposal, and while that continues to provide improvements in the relevant rules, this slippage is regrettable both substantively and for not having been open to more public discussion. Backtracking by the SEC on this important matter of stock options reinforces my determination that Congress must act to deal with the problem of executive compensation that is now unconstrained by anything except the self restraint of top executives, a commodity that is apparently in insufficient supply.

Frank also indicated that he will seek legislation to allow shareholders to vote on executive compensation. If this legislation succeeds, it will be the second direct foray of the federal government into corporate governance issues, an area of U.S. law that traditionally has been the province of state law. (The first, of course, being the Sarbanes-Oxley Act, which set requirements for issuer board composition.)

So, I guess my prediction that Barney Frank will hold hearings on executive compensation is a no-brainer. (I guess we'll have to see about the professors and Lake Woebegon.) However, if Frank does go ahead with corporate governance legislation rather than some kind of windfall tax, I'll have been happily proven wrong.

Congress giveth and Congress taketh away (Part 2): The Financial Services Regulatory Relief Act

As mentioned in my previous post here, two laws recently have been passed by Congress and signed by President Bush that will have a big impact on the regulation of U.S. financial markets. Neither of these laws have received much press, and I suspect that most Congressmen didn't even know what they were voting on when they agreed to them. They don't directly touch on issuers or investors, so, unlike Sarbanes-Oxley, they are pretty much under the radar screen. But they both will have a profound impact on what the Securities and Exchange Commission's Division of Market Regulation does.

The first of these laws is the Credit Rating Agency Reform Act. As I discussed, this new law has plopped into the SEC's Division of Market Regulation broad new powers to regulated some of the most powerful financial firms in the world--credit rating agencies such as Moody's Investor Services and Standard & Poor's. The second new law does the opposite--the Financial Services Regulatory Relief Act takes away a good dollop of the SEC's powers over banks that offer both retail banking and brokerage services (which are most brokerage houses these days). Section 101 contains the really juicy part:

SEC. 101. JOINT RULEMAKING REQUIRED FOR REVISED DEFINITION OF BROKER IN THE SECURITIES EXCHANGE ACT OF 1934.
(a) FINAL RULES REQUIRED.

(1) AMENDMENT TO SECURITIES EXCHANGE ACT. Section 3(a)(4) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(4)) is amended by adding at the end the following:

(F) JOINT RULEMAKING REQUIRED. The Commission and the Board of Governors of the Federal Reserve System shall jointly adopt a single set of rules or regulations to implement the exceptions in subparagraph (B)..

(2) TIMING. Not later than 180 days after the date of the enactment of this Act, the Securities and Exchange Commission (in this section referred to as the "Commission") and the Board of Governors of the Federal Reserve System (hereafter in this section referred to as the "Board") shall jointly issue a proposed single set of rules or regulations to define the term "broker" in accordance with section 3(a)(4) of the Securities Exchange Act of 1934, as amended by this subsection.
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"Damn!" I can hear you saying. "Nobody told me law stuff was going to be on the exam!" Don't worry, it just means that the SEC has to coordinate with the Federal Reserve when issuing rules and regulations regarding stock brokers. As Jim Hamilton explains here, "The measure is intended to ensure that regulators do not create a new and burdensome maze of requirements that would disrupt or interfere with the business practices of banks and thrifts that offer traditional bank products and services." As Hamilton also explains, this bill has been in the works for several years, as had promises by the SEC to coordinate its brokerage rules with banking regulators. Now, with this new law, it will have 180 days to do so. (You can also check out the SEC's press release on the matter here.)

Cutting through all the legal language and political niceties, what this means is that the SEC will have to coordinate its rules on brokers with the Federal Reserve. And, as all of us know, the Federal Reserve gets to wear the pants in that relationship. (This is the hierarchy in U.S. financial regulation: When the Fed and the SEC are involved, the Fed is butch. Basically, when the Fed is involved with anybody, it gets to be butch. When the SEC and the Commodity Futures Trading Commission are involved, the SEC is the dominant player. When the SEC and the Treasury Department are involved, the SEC stalls until the next election. When any federal financial regulator other than the Fed is involved with a State Attorney General, the federal regulator will get this deer-in-the-headlights look and start arresting or suing everybody in sight.)

There are several reasons for this change (other, that is, than the stated reason Hamilton notes--to cut down on conflicting cross-functional regulation.) The Gramm-Leach-Bliley Act broke down the barriers between retail and investment banking, and since then, every local bank has opened a brokerage arm to sell securities to its customers. (You've probably gotten these brochures yourself when you opened a bank account and were offered "investor services" as well.) All of these local banks are much more comfortable dealing with the Federal Reserve than the SEC. And, let's be honest--so is pretty much everybody else. It's been said that the Federal Reserve is like the Good Samaritan who nurses your wounds after you've been mugged, but lets the mugger escape; the SEC, on the other hand, has been described as the cop who ignores you as you lie bleeding on the floor and instead chases down the mugger and beats him to a pulp. If you are a potential mugger (and, since we're being honest here, most brokers are), who would you prefer to be regulated by?

So the SEC's Division of Market Regulation is very concerned right now that the Financial Services Regulatory Relief Act of 2006 has made them irrelevant. The ironic part about this, of course, is that it is not the Division of Market Regulation that has made the SEC so feared and loathed among bankers-cum-brokers. (That honor goes to the SEC's Office of Compliance, Inspections and Examinations.) If the SEC behaves like a bureaucracy (and I'm guessing it will), this will mean that we can expect the Division of Market Regulation to do everything it can to hang on to whatever power it has left. And this may not be a good thing, if it gets in the way of other reforms designed to improve the competitiveness of the U.S. capital market.

Congress giveth and Congress taketh away (Part 1): The SEC and credit rating agency legislation

Two laws recently have been passed by Congress and signed by President Bush that will have a big impact on the regulation of U.S. financial markets. Neither of these laws have received much press, and I suspect that most Congressmen didn't even know what they were voting on when they agreed to them. They don't directly touch on issuers or investors, so, unlike Sarbanes-Oxley, they are pretty much under the radar screen. But they both will have a profound impact on what the Securities and Exchange Commission's Division of Market Regulation does.

The first of these new laws is the Credit Rating Agency Reform Act. (The second will be discussed in a different post.) This is an interesting law with a very convoluted history that some day will make a good study for public choice theorists.

The story basically goes like this: The SEC requires investment banks and broker-dealers and other people who hold your money on your behalf to keep some of that money in reserve to cover losses that the company might experience as a result of operational failures, employee theft and the like. (The risk you face as a result of your bad investment is your own problem, but the idea is that you should be protected from losses that happen if somebody at the company types in the decimal point in the wrong place after you place an order.) Since 1975, the SEC has said that if the investment company keeps some of its money in particularly safe and liquid assets (i.e., investments that most likely aren't going to lose much value tomorrow and can be sold on a moment's notice), then the reserves don't have to be so big. But how do you know if an asset is safe and liquid? Well, one way is to look at the asset's credit rating. If a rating agency says U.S. government bonds are "Triple-A" (in other words, short of a nuclear holocaust, the U.S. government is going to pay you back, particularly since it can print the money to do so), then an investment company holding a lot of those bonds doesn't have to set aside as much cash as would a company investing in "junk" (very risky) bonds or equities.

But which rating agencies are acceptable? Some (such as Moody's, Standard and Poors, Fitch, etc.) are famous and respected. The one I just started in my basement where I assign credit ratings based on the shape of chicken entrails is somewhat less so. So, as part of this 1975 SEC "Net Capital Rule," the SEC said that if the credit rating agency is "nationally recognized," its ratings could be used in determining reserve requirements. So, how do you know if a rating agency is nationally recognized? Up until now, if you were an investment firm, you sent a letter to the SEC asking if they would take an enforcement action against you if you relied on XYZ Ratings, and, after some time (maybe a long time) and after deliberating deep within the SEC's offices, they just might send you a "No Action" letter saying they won't go after you if you do. Or they might not. And, if some rating agencies are to be believed, the SEC rarely tells you why they make the decisions they do, or what they are looking for. As for the SEC, they say they merely poll "the market" to see how widely a given rating agency's ratings are used.

It is an opaque system. Worse, it's arguably anti-competitive. Since 1975, the SEC and a number of other government agencies (and foreign governments) have piggy-backed on this "NRSRO" (Nationally Recognized Statistical Ratings Organization) system for banking, mutual fund and insurance regulation. Even private companies use the SEC's NRSRO status in their own contracts, under the theory that if a rating is good enough for the SEC, it's good enough for them. In the late 1970s, there were 7 NRSROs, but by 2000, mergers had cut this number down to 3. Since then, and under pressure, the SEC has increased this number to 5 (adding the Toronto-based Dominion Bond Rating Service and A.M. Best to Moody's, Fitch and S&P).

This situation has annoyed issuers and smaller rating agencies. Issuers pay NRSROs to rate them, because the NRSROs have figured out that information about their ratings spread so quickly that they face a collective action problem with fees. Nobody (with the exception of Bloomberg and other news services) will pay for their ratings, since they can get it free through the gossip mill. So, instead, the big rating agencies charge issuers for a rating, much like your bank charges you to run your credit score for a car loan. Further, issuers have to pay for more than just one rating, since investors want a second--or third--opinion before parting with their money. Making it worse, they don't want a rating from just anybody. If you don't go with an NRSRO, the investors will just assume you paid me off to rig the chicken entrails in such a way to get you a good rating. (And they'd be right.) So issuers are facing an oligopoly, and new entrants are closed out of the market.

But while issuers have been peeved, in the grand scheme of things NRSRO ratings, while overpriced, are not nearly as overpriced as are underwriting fees. (If you have a $100 million bond offering, you really don't care if S&P sends you a bill for $75,000--particularly since your investment banker's bill will probably be $6-7 million.) At the same time, new entrants to the ratings market tend to be small and politically weak. Consequently, there really wasn't much political momentum for change. That is, until Enron. Enron raised investor hackles because all of the major rating agencies missed the boat and failed to predict the company's collapse until just beforehand. (In their defense, of course, it should be noted that the immediate reason for Enron's collapse actually was a ratings downgrade, since Enron had a number of large loans that came due immediately upon Enron's debt being downgraded to junk status. Nonetheless, Moody's, S&P and the rest seem to have taken at face value whatever Enron was feeding them beforehand.) This event changed the politics of NRSRO recognition and put pressure on the SEC to regulate the industry and open the doors to competition.

In early 2005, after unsuccessfully petitioning the SEC to grant his little operation NRSRO status, Sean Egan, the owner of Egan Jones Ratings Co., asked his congressman, Michael G. Fitzpatrick (R-Penn.) to introduce legislation that would basically take from the SEC the authority to determine which rating agencies could be NRSROs. The resulting legislation, which passed the House this past summer, was called the Credit Rating Agency Duopoly Relief Act ("duopoly" referring to the 70+ percent market share of Moody's and S&P.) House Republicans strongly supported the bill, not so much because they thought that the ratings industry needed more competition, but because certain House staffers instinctively distrust the SEC and Fitzpatrick is a first-term congressman facing a tough reelection battle. Legislation bearing his name might lend him some campaign ammunition (though why his Pennsylvania constituents would care about ratings agency legislation is beyond me). The House bill would have prohibited any rating agency from issuing ratings in the United States unless it was first registered with the SEC, and would have mandated that the SEC would permit registration of any rating agency that had three or more years experience and no obvious conflicts of interest. (How this mechanism would actually promote competition is also beyond me, since you couldn't do business if you weren't registered, and you couldn't register if you hadn't been doing business for at least three years. But, of course, Egan Jones had been doing business for more than three years, so who cares, right?)

This bill passed the House by a wide margin. But a funny thing happened on the way to the Senate. The Senate's version of the bill, which was only drawn up after the House bill had passed, largely paralleled the House version but for a few, very important, changes. In particular, rather than mandating that the SEC permit any rating agency to register as an NRSRO, the Senate version said the SEC should designate any rating agency an NRSRO provided the rating agency submitted certifications from at least 10 financial firms stating that they actually rely on the agency's ratings. The SEC is also given the power to set other rules to determine who qualifies as an NRSRO, and any registered NRSRO is subject to SEC rules and oversight. (Prior to this law, there were questions about whether the SEC had the legislative authority to regulate the NRSROs--see, for example, former SEC Chairman William Donaldson's speech here). This Senate bill passed and the House agreed to the Senate version without hammering out any differences in conference. President Bush signed the bill into law on Sept. 29.

So, what does this all mean? It means that that while the SEC has been forced to clarify how it designates certain rating agencies as "nationally recognized," the SEC also has considerable new powers to regulate them. At the same time, Congressman Fitzpatrick and his constituent, Sean Egan, seem to have lost control over the truck they set in motion. Rather than opening the NRSRO designation to everyone, the Credit Rating Agency Reform Act actually tightens who can qualify as an NRSRO and gives the SEC broad new regulatory powers. Not exactly what Mr. Egan wanted, I suspect.

This new law likely will have two broad results. The first is that it may actually increase the number of NRSROs. Most of these new NRSROs, however, probably will not be small firms like Egan Jones, but foreign companies like JCR or R&I. A second result may be a new raft of "me-too" foreign legislation, particularly in Europe. The entire issue of credit rating agencies is more political in Europe than in the United States, with European issuers often complaining that the big "Anglo-American" ratings agencies don't understand how business is conducted on the Continent, and hence give them too low ratings because of under-funded pensions and the like. A new set of European laws on rating agencies likely will be more protectionist and focus on "issuer rights" rather than actual ratings quality. This could have a detrimental impact on the cost of capital on European markets.