Fixing the Securities and Exchange Commission

The following are remarks delivered by Securities and Exchange Commission Chairman Mary L. Schapiro as part of the Brodsky Family Fund Lecture Series at Northwestern University School of Law on Nov. 9.

This marketplace demands that we constantly find new approaches and strategies, build new tools and think of new ways to outcompete the competition.

This push for innovation constantly changes the face of the financial industry as smart minds discover new ways to create wealth or manage risk. No doubt, great good can come from this. It can enable vibrant markets where entrepreneurs can access the capital they need to transform their vision into new products and personal success.

But innovation creates challenges as well.

It can foster incredibly complex financial products that fail to live up to buyers’ expectations but generate fees for their creators and sellers. This complexity can bury important information needed for effective decision making so that even the most sophisticated are unable to make informed judgments about risk and payoff. Finally, it can mask old-fashioned manipulation and fraud.

But whether innovation is used for good or ill, to improve the system or to manipulate it, it creates a challenge for regulators with limited resources trying to keep up with the industries they regulate.

This was particularly true when I became chairman of the SEC in late January 2009, in the wake of the financial crisis.

At that time, we weren’t just trying to keep up, we were trying to catch up.

The SEC was then — and is today — an agency full of talented and dedicated men and women, many of whom chose public service over far more lucrative private-sector careers.

But when I arrived, it was clear that the agency had fallen behind.

It was underfunded and understaffed. And after an era in which deregulation was the prevailing fashion, it had lost focus on its core mission. We were behind and falling further behind.

And there were other challenges. The financial crisis revealed real cracks and gaps in the SEC’s oversight. Investor confidence in our capital markets was dropping as fast as the Dow [Jones Industrial Average] was. And just weeks before I arrived, Bernard Madoff had confessed to his massive fraud.

So it is not surprising, perhaps, that some people were asking if we even needed an SEC at all. But that was the wrong question. The right question was: “How can we make the SEC better?”

In the wake of a financial crisis, it was clear to me that we needed an SEC more than ever — an SEC that was far more dynamic and effective.

But if the SEC were to remain intact, I knew that it wasn’t enough to just say we needed an SEC; we also needed to demonstrate that we were up to the job.

To start off, that meant owning up to our mistakes and learning from them.

For the SEC, the Madoff Ponzi scheme was a case in point.

In the wake of that failure, our inspector general was charged with preparing a report that outlined many of the shortcomings that allowed this fraud to go undetected over a number of years. That report was issued a year ago.

But we had set out to understand what went wrong and improve our performance from my very first day. By the time the definitive report was issued, we had re-examined and reformed the way we operate. We had taken dramatic action to improve the performance of our enforcement unit, and we already had a meaningful head start on the reforms we all agreed needed to be undertaken.

Rather than sticking that report in a drawer and hiding our heads, we knew we needed to learn all we could from it — as individuals and as an institution — and figure out how not to make the same mistakes again. So I sent it to every one of our 3,700 employees and encouraged them to read it. Together with the report, I sent along a sampling of the victims’ letters, not just for everyone to read about their anger and disappointment but to remind ourselves about how important it is to do what we do every day — to appreciate the very suffering that our work can prevent.

But that was just a first step. We needed to do much more. And we had to do it all at once.

When I walked in the doors of the SEC on Jan. 27, 2009, I was overwhelmed by the needs of the agency. And I knew that if we were to achieve what American investors needed, we would have to significantly increase our institutional capacity and refocus on our core mission by vigorously enforcing the securities laws, working to reform our regulatory system and embracing an aggressive investor-focused agenda.

We needed to build a foundation and an infrastructure capable of supporting a stronger and more vital agency. That is, we needed to invest in talented people and provide them with essential technology. We needed new leadership across the board, new skill sets and new ways of operating.

In short, we needed to show that the SEC was on the job — and up to the job — by embracing change and innovation with the same energy as the financial markets.

From the start, the one thing we knew would be critical to our success was developing an infrastructure — one made up of the right people and the right technology.

So I began by bringing in a new group of leaders: men and women from inside and outside government who shared a more strategic vision of our mission, had the drive and energy to shake things up and possessed the experience to strengthen our knowledge base.

We hired new skill sets — not just attorneys and accountants but experts from the cutting edge of finance. We brought in people deeply familiar with derivatives, hedge funds, trading and risk management to keep pace with new financial products and strategies. That is, we brought in people who could connect the dots of multiple risks and regulatory concerns, see the picture that emerged and devise an appropriate response.

And to ensure that every employee could benefit from the growing pool of talent at the SEC, we began to create a culture of collaboration — a culture where the staff is encouraged to look outside their own office or division and seek the views of others. When I interviewed people for senior management positions, a key attribute I looked for was an appreciation for teamwork and the ability to work collaboratively. In fact, I even created a new Division of Risk, Strategy and Financial Innovation that serves as a mini-think tank within the agency to support the policy offices and enforcement.

We also invested in training so that our inspectors, examiners and attorneys could better keep pace with those we regulate. A little statistic to illustrate how far we had fallen behind: When I arrived, the SEC was spending one-fifth as much as the [Federal Deposit Insurance Corp.] spent on training employees. Since then, our training budget has tripled.

Today, when you look around the agency, you see smart people who are dedicated to a mission, willing to work across organizational lines and eager to seek out the training to be better at what they do.

But in today’s high-tech markets, dedicated employees need to have the technology to support their efforts. Unfortunately, the agency was far behind. By 2009, several years of significant underfunding had left the SEC with dated technology. While Wall Street was harnessing computers so powerful that only the speed of light held them back, budget shortfalls between 2004 and 2007 forced the SEC to cut IT investment by more than half.

Only in the last fiscal year have we been able to begin investing in several new or improved IT projects and systems.

Our earliest technology initiative was a direct and important response to the Madoff scandal: creating a database that would allow us — for the first time — to centralize, organize and search the incredible volume of tips and complaints we receive.

Another key investment has been establishing a system to manage the millions of documents we obtain — to improve the management of our enforcement cases and the consistency of our inspections and examinations.

Though we are making progress on technology, we still have far to go to keep up with our markets. The SEC regulates the largest markets in the world, where roughly 8 billion shares of listed stocks are traded on an average day. But we don’t have routine access to data and tools that would allow us to quickly and efficiently reconstruct trading to determine what causes events like the flash crash of May 6. We don’t have the capacity to identify new trading strategies and determine if they are making markets more stable or less. Instead, we still must attack each new problem as it arises, and often build new infrastructure on the fly to handle it.

CORE MISSION

At the same time we were reinforcing our work force and exploiting technology, we were also refocusing on our core mission — our guiding principle — of putting investors first.

It was a principle that guided us as we reformed and bolstered our enforcement program.

It was a principle that guided us as we set about proposing new rules for the financial services industry.

And it was a principle that guided us as we supported legislative initiatives designed to fill gaps and update our regulatory framework.

Enforcement is the cornerstone of the SEC’s mission.

So I made hiring a new head of our enforcement division a top priority. I wanted a pit bull with management skills and I got one — with a résumé that included prosecuting terrorists and heading the legal department of an investment bank.

We restructured that division, eliminating a layer of management and putting seasoned veterans back on the front lines. We streamlined procedures for opening investigations and for setting penalties for corporate defendants. By this spring, we were staffing specialized units with expertise in areas like derivatives, hedge funds and municipal securities. And we created a new office specifically to serve as a central location for handling tips, complaints and referrals.

The results are already speaking for themselves. Despite the demands of comprehensive reorganization, we launched major financial crisis investigations and returned record sums to harmed investors.

As we were reinvigorating the enforcement division, we were also developing a rulemaking agenda intended to protect investors. The agency has engaged in significant rulemaking in areas as diverse as market structure, corporate disclosure, governance and money market fund reform.

We worked to put investors first by bringing greater transparency to the markets:

• By adopting rules that resulted in more-detailed disclosure of qualifications by candidates for corporate board seats and by requiring companies to disclose in detail their process for managing risk.

• By proposing rules that will improve the offering process for asset-backed securities, requiring the reporting of detailed data on each loan in an asset pool.

• By adopting rules to improve the quality and timeliness of the disclosure of material events related to municipal securities, including events like payment defaults and rating changes.

• And by proposing rules that alert investors to “window dressing” by companies that may be improving the appearance of their balance sheets with short-term borrowing at the end of a reporting period.

We have worked to put investors first by making the markets more fair and leveling the playing field:

• We have proposed rules that would limit the continuing sales charges that mutual fund investors pay.

• And we have adopted rules curbing “pay to play” practices where investment advisers make campaign contributions in hopes of influencing decisions regarding the management of public-sector monies — like pension funds.

We worked to put investors first by bringing greater stability to the financial markets:

• We adopted rules strengthening the oversight and resiliency of money market funds — which had to be propped up during the financial crisis by a federal government guarantee.

• Just [recently], we adopted a rule that limits the ability of brokers to give clients “direct access” to exchanges, by requiring that risk controls be put in place before a customer can get that access.

And we worked to put investors first by increasing our effectiveness as an agency:

• We instituted new safeguards, like better controls over the investor assets that an investment adviser manages — controls that subject advisers with custody to surprise audits by qualified third parties who can confirm that the assets an adviser says exist in an account really do exist.

• And we proposed a rule that would require self-regulatory organizations to establish a consolidated-audit-trail system which will allow regulators to track information about orders received and executed across the securities markets. This will allow us to track data across multiple markets, products and participants in real time, and to better analyze both suspicious trading behavior and unusual market events.

I believe our efforts have begun to make the financial markets more transparent, stable and fair for investors of every size. And our efforts are significantly increasing our ability to enforce rules and protect investors from manipulation and fraud. It’s been a broad effort, touching virtually every facet of the securities industry. But each initiative shares a common goal: that of putting investors first.

REGULATORY REFORM

Of course, our commitment to investors also shaped the way we engaged in the regulatory reform debate. So in addition to executing an investor-focused rulemaking agenda and building the institution, I took on a third job when I joined the SEC: helping fill gaps in our regulatory framework.

As financial reform legislation came together, we provided technical assistance and worked with Congress to improve investor protection and to gain needed oversight over opaque and demonstrably risky market sectors.

In the end, the legislation assigned the SEC more than 100 rules to write and 20 studies to conduct.

One of the biggest challenges will be bringing the over-the-counter derivatives market into the daylight [by] building an entire regulatory regime for a market whose notional value is measured in the trillions of dollars, from the ground up. We are working closely with the Commodity Futures Trading Commission to develop requirements for new trading and clearing platforms, regulate the business conduct of dealers, and ensure trade reporting and transparency.

And there are dozens of other important responsibilities for the SEC in the new law.

For the first time, for example, the SEC will have oversight responsibility for managers of hedge funds and other private funds. This will allow us both to address investor protection concerns and to monitor this important market sector for systemic risk.

We are expanding our oversight of credit-rating agencies, working to eliminate conflicts of interest that may influence their ratings of securities and bringing their methodologies into the sunshine so investors can judge for themselves how accurate their ratings will be.

Corporations will be subject to increased disclosure regarding executive compensation — where shareholders will now have a non-binding up-or-down vote on senior executives’ pay, and companies will compare executive compensation to both financial performance and the salaries earned by a company’s other employees.

In the realm of retail investing, we will be exploring the imposition of a fiduciary duty on all financial professionals. Today, if you invest your money with the help of a registered investment adviser, they are held to a fiduciary standard of conduct that requires that they put your interests ahead of their own and avoid or reveal any conflicts of interest. If you go to a registered broker-dealer, however, they are held to a “suitability” standard, and they don’t necessarily have to reveal all conflicts, like the fact that they can receive a higher commission for steering you into one fund rather than another.

Under the legislation, we’ll be studying how these disparate standards of conduct affect retail investors. And we’ll have the authority to write rules that would impose a harmonized fiduciary standard on all investment professionals when they provide advice about securities to retail investors, regardless of the title on their business cards.

Putting these and the many other requirements of Dodd-Frank into place will take a tremendous amount of work. But the result will be well worth it: an SEC significantly better able to execute its investor protection mission.

But of course, just when you think you might be able to pause for a deep breath and think everything is OK, the Dow drops nearly 600 points in a matter of minutes and then gains most of that back even more quickly.

Moments like that can be revealing. It’s when you find out if you’re on the right track — if you have the infrastructure, the people, the culture and the vision you need to respond to the challenge. And we did.

Within hours of the May 6 events, cross-functional SEC teams were collaborating with exchange representatives, with the self-regulatory agencies and with other financial regulators on a coordinated response.

Within two weeks, the staffs of the SEC and CFTC released a preliminary report. And shortly thereafter, the SEC posted for comment proposed rules that would create a uniform circuit breaker system to halt trading for individual stocks experiencing unusual volatility.

By June, a pilot program was in place, and by September, we were expanding it. For the first time, stocks in the S&P 500 and Russell 1000, as well as several hundred exchange-traded funds, have their trading halted if the price moves by 10% or more in five minutes.

These pauses are designed to give market participants time to provide liquidity and for the affected security to attract new trading interest and establish a reasonable market price so that trading can resume in a fair and orderly fashion.

The circuit breakers have been triggered 15 times since being put in place. And while we are likely to modify them based on our experience, we believe they have worked well to protect investors who rely on the financial markets price discovery function and to limit the effect of erroneous quotes.

Also in September, the SEC approved new rules clarifying the process for breaking clearly erroneous trades. After May 6, more than 20,000 trades were nullified because they were executed more than 60% away from their pre-crash prices.

At the end of September, the staffs of the SEC and CFTC released a final report of their findings regarding the events of May 6. The report has also inspired a discussion of additional potential changes to the securities markets’ structure that will further increase stability and diminish the potential for another similar event.

It was important work. But the fact is, we didn’t just drop everything else — because as a regulator, we can’t.

So at the same time we were working around the clock to analyze and respond to May 6, we continued to push forward with our rulemaking agenda. Our enforcement division continued to launch investigations and bring charges. And we prepared for the passage of the Dodd-Frank legislation, hitting the ground running as soon as the bill was signed.

Regulation — especially market regulation — is a constant work in progress. The months after May 6 tested us in ways we never expected.

We will always be striving to adapt to market changes and innovation.

But by focusing on basics — strengthening our infrastructure and focusing on our core mission — we have made real progress.And by matching the markets’ commitment to innovation and progress with our own drive to protect investors and excel, we are becoming an ever-more-effective advocate for in-vestors in a very complicated time.

Related Topics: Securities and Exchange Commission