Roel Campos to leave SEC

Democratic Commissioner Roel Campos announced today that he will be leaving the Securities and Exchange Commission by the end of September. The media is making a big deal out of the fact that Campos is the SEC's first Hispanic commissioner and a Democrat in a highly divided Commission. However, Campos is also the "international" commissioner--he represents the SEC before a number of international organizations and is currently the Vice Chairman (and prospective chairman) of the developed markets committee of the International Organization of Securities Commissions. With Campos leaving, SEC Chairman Cox will have to nominate someone new to represent the SEC before the world--though, given Cox's own interest in international matters, I wouldn't be surprised if he takes up this job himself. If he does, we can expect a new emphasis placed on IFRS-US GAAP convergence and mutual recognition.

The conspiracy theorist in me expects Paul Atkins to leave soon as well, in a quid pro quo that will reduce the SEC to three commissioners. The Financial Times has reported that Atkins may be heading over to the Commodity Futures Trading Commission. Even if he does not, his term ends in a year and he may be interested in more remunerative work even before then. As it stands, the 5-member Commission will soon be down to 4 members, only one of whom is a Democrat at precisely the time that some very important decisions are coming due and an upcoming election season.

If Atkins leaves for the CFTC, I expect Bush will leave the SEC with three commissioners for the remainder of his term. This is because, despite all the talk about a shift in the balance of power, the current Commission is ideologically dysfunctional. Previous SEC chairmen (particularly Arthur Levitt) ran the SEC as a corporate chairman--i.e., largely by fiat, with the four other commissioners more or less falling in line. However, starting with Harvey Pitt and his battles with fellow intellectual heavy-weight Harvey Goldschmid, individual commissioners started having their own ideas and pursuing their own political agendas. The media story on current SEC chairman Cox's predecessor, William Donaldson, was that he "sided" with the Democrats and chaired a fractious Commission. However, the same fractures are starting to appear with Cox as well. And the source of these cleavages? Atkins.

Atkins, in particular, is a thorn in any Republican SEC chairman's side, basically because he has yet to see a securities regulation he likes. He is an ardent deregulator, and such views can be particularly unhelpful to more "responsible" (i.e., vulnerable) Republicans during an election season. Cox is no investor-hugging hippie, but he does recognize that an SEC that appears to be in the pocket of industry is not something good for his party. (Hence his vote with the Democrats to petition the Solicitor General to file an amicus brief on behalf of the investors in the Stoneridge case.) Atkins, on the other hand, would rather be ideologically pure than in power. Furthermore, he has a tendency to get the other Republican commissioner (whoever that might be) to get onboard with him.

Reducing the Commission to three members might, then, help Cox pursue his own (and his party's) wider agenda. Under a 2-1 Commission, Cox likely could count on support from his remaining fellow Republican commission Kathleen Casey, and Democrat Annette Nazareth likely would go along to get along.

A nice, quiet SEC for the remainder of George W.'s term. What's not to like?

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.

An SEC blueprint for mutual recognition?

The Harvard International Law Journal recently published an article by two members of the SEC’s Office of International Affairs which proposes that the SEC should adopt a “substituted compliance” approach to foreign stock exchanges and broker-dealers. (See A Blueprint for Cross-Border Access to United States Investors: A New International Framework.) The authors outline an approach under which the SEC would evaluate a foreign jurisdiction’s securities regulations and enforcement history and, if the regulations and enforcement philosophies are similar enough to those in the United States that investors are properly protected, the SEC would allow stock exchanges and stock brokers from that country to operate in the U.S. without having to fully register (and be regulated by) the SEC. If this proposal were to be adopted, it would signify a major change in how U.S. capital markets are regulated.

Currently, stock exchanges and broker-dealers wishing to offer their services to investors in the United States must register with the SEC and be subject to SEC oversight. American investors, of course, can invest in foreign securities that are not registered with the SEC. But U.S. brokers can’t suggest these securities to American investors, and foreign brokers can’t volunteer their services. To invest in non-registered foreign securities, American investors must first research the foreign securities on their own, and either ask their own broker or a foreign broker to conduct the transaction for them. Usually, this entails having to pay brokerage fees twice — once to the U.S. broker and again to the foreign broker who actually executes the trade. U.S. investors seeking out foreign brokers on their own will often find the brokers reluctant to conduct anything more than the most basic transactions for fear of falling under the SEC's watchful gaze.

According to the article's authors, this traditional approach protects investors, but at a cost. Yet, because other jurisdictions have adopted higher investor protection standards and American investors have shown an increasing appetite for foreign investment opportunities, Tafara and Peterson question whether the cost is always worth the benefit. Instead, they suggest that a new approach by which the SEC would coordinate with "like-minded" foreign jurisdictions would reduce transaction costs for investors, lower unnecessary regulatory barriers for foreign broker-dealers and exchanges, and increase competition in the financial services market, all while preserving critical investor protections.

The Tafara/Peterson proposal comes with some strings attached. First, the foreign government would have to have similar laws and “enforcement philosophies” as in the United States. Obviously, it’s open to interpretation about what that means. Areas mentioned in the article include:

… a comparability assessment of financial and non-financial statement disclosure requirements, the robustness of the accounting standards required in the jurisdiction, the adequacy of local auditing standards, and auditor oversight controls. It would also entail a comparability analysis of other issuer requirements designed to ensure that issuer disclosures are accurate and complete. Such requirements might include a comparison of the jurisdiction’s corporate governance, internal controls, director independence, and shareholder protection laws and regulations.

The foreign government would also have to sign an agreement with the SEC allowing for the exchange of enforcement and inspections information. And, of course, there would have to be full reciprocity — U.S. brokers and exchanges would have to be given similar access to investors in the foreign country.

The SEC would not cede all power under this arrangement. Foreign exchanges and broker-dealers would still be subject to U.S. anti-fraud laws — in particular, Rule 10b-5. However, the article seems to imply that only the federal government would have the power to enforce these anti-fraud provisions. Shareholder lawsuits would be limited to those permitted under the foreign country’s rules. (Currently, U.S. shareholders have an implied right of action under Rule 10b-5 — see here.) In addition, the foreign exchanges and brokers would have to make certain basic disclosures to the SEC, and, before engaging in any business, would have to provide U.S. investors with a warning that informs them that U.S. laws won’t apply to their transactions.

The Harvard ILJ has also published a series of comments on the Tafara/Peterson Blueprint, from Ontario Securities Commission vice-chair Susan Wolburgh Jenah (Commentary on “A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework”), Citigroup general counsel Edward F. Greene (Beyond Borders: Time To Tear Down the Barriers to Global Investing), TIAA-CREF’s general counsel George W. Madison and associate general counsel Stewart P. Greene (TIAA-CREF Response to “A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework”), and Harvard Law Professor Howell E. Jackson (A System of Selective Substitute Compliance). Wolburgh Jenah, Citigroup's Greene, and Jackson support the proposal. Greene calls the proposal “long overdue...Investing in non-U.S. markets is no longer the exclusive province of megainstitutions or the ultrawealthy; it is an essential component of prudent portfolio diversification for all investors.” Jackson agrees, and adds, “By temperament, academics like to think of themselves as being well in the forefront of government bureaucrats. But here I find myself in the uncomfortable posture of having to play catch-up with senior SEC staff who have advanced a far more ambitious program than my own.” However, TIAA-CREF’s Madison and Greene warn that the proposal is dangerous, since the SEC may come under intense political pressure to recognize a foreign jurisdiction’s rules as substantially the same as those in the U.S. when, in fact, they are not.

Interestingly, Professor Jackson, who, otherwise strongly supports the proposal, agrees that this is the most significant risk:

...there are good reasons why federal agencies do not like to get in the business of picking favorites among foreign governments. While it is possible to develop short blacklists of off-shore havens that clearly have substandard controls over money laundering and tax reporting, it is a more difficult task to distinguish between major jurisdictions, some of which will be valued political allies, on the basis of whether their regulatory controls are acceptable substitutes for U.S. oversight. Official government distinctions of this sort tend to generate reactions from the State Department and one can imagine the complexities that will arise when the first Turkish broker-dealer seeks an exemptive ruling while renegotiation of military basing rights are pending elsewhere in the government.

TIAA-CREF also raise other (somewhat strange) objections:

A key assumption of this new framework is the need for retail investors to have greater access to foreign investment opportunities. In order to deliver this greater market access, Tafara and Peterson propose measures that would lower the barriers to entry for these investors. Yet it can be argued that the lowering of these barriers may not be entirely in the interest of retail investors since these barriers can serve to protect them. Retail investors currently face high barriers, such as having to use foreign broker affiliates and facing multiple layers of fees, that make direct investment abroad difficult, although not impossible. In dealing with these barriers, the retail investor is well aware that they are going into foreign markets and leaving behind the protection of the SEC regulatory framework.

I take it this means TIAA-CREF believes that it’s good that US investors have to pay a lot more to buy foreign securities, because that keeps them from doing something stupid with their money. I’m not sure that’s in the spirit of U.S. securities laws, but, hey, the TIAA-CREF folks are professional investors, not stupid money like you or me. (Though in the following few sentences, Madison and Greene acknowledge that TIAA-CREF itself doesn't face these higher transaction costs, since it has obtained exemptions that allow it to deal directly with foreign exchanges and brokers without the exchanges or brokers having to fear violating U.S. law.)

At the end of the day, it's not at all clear how widely supported these ideas are within the SEC. While it is true that SEC Chairman Christopher Cox (see speech here) and SEC Commissioners Paul Atkins (see here) and Roel Campos (see here) have all spoken in favor of various aspects of “substituted compliance,” its seems likely that such a radical departure from current SEC policy will be an uphill battle. Nonetheless, if this proposal does gain traction, one wonders what effect it may have on other markets. Does this increase, or decrease, the value of the NYSE-Euronext merger? Will it add pressure on the London Stock Exchange to merge with NASDAQ? And, perhaps more long-term, since the “substituted compliance” framework means the foreign jurisdiction must have a regulatory approach similar to that in the United States, does this mean that Sarbanes-Oxley will end up being a major U.S. export? Or, conversely, if the foreign rules must be similar (but not identical) to the U.S. approach, will this create future pressures on the SEC to scale back its regulation if U.S. investors seem to prefer a foreign approach?