Financial Regulatory Reform: The Good, The Bad, and The Ugly

Regulation of the United States financial system throughout its history could be described as disjointed…at best.  In response to the current regulatory framework, the administration presented its plan to overhaul the system with an emphasis on consolidating a fractured system of multiple regulators.  It is in no way a guarantee that fewer individual regulators will translate into better regulation, but investors should feel cautiously optimistic that they will be better protected once the plan is implemented.

Of course the devils in the details, however on the surface the following provisions look promising: improved hedge fund regulation, derivatives oversight, elimination of the Office of Thrift Supervision and the creation of an agency that will oversee financial products targeted at consumers.

Hedge funds have traditionally operated outside the regulators’ reach.  Unfortunately, it was only when hedge funds either collapsed or committed fraud that regulators got involved.  Because they now control such a huge swath of capital and are responsible for such massive trading volumes, hedge funds pose significant risks to the system.  Moreover, hedge funds are also big players in the commodities trading industry and have the capacity to impact food and energy prices.  Registration of these funds, which includes confidential disclosures about strategy and assets under management, would help regulators assess their stability and impact on the system.

Derivatives, to borrow Warren Buffet’s expression, are financial weapons of mass destruction.  Whether used to insure against losses, as an investment or as a hidden way to ramp up leverage, the use of derivative instruments needs to be controlled.  The new plan to introduce transparency into this opaque side of the financial industry is well overdue.  Exposure to these instruments, to recall, is what caused A.I.G. to collapse.

The elimination of the Office of Thrift Supervision will help guard against “regulator shopping.”  One central bank regulator makes a lot of sense.  And the creation of a special agency to oversee products targeted at consumers is certainly a good idea.  One concern however, is that this agency does not oversee securities sold to individual investors.  Rather, this new agency will focus on credit cards, loans and annuities.  As we’ve seen, Wall Street approaches the sale of securities in the same way the corner electric store sells microwave ovens; therefore they should be regulated as such.

Oversight of securities sold to investors remains with the SEC and FINRA.  While the SEC has made strides in the past few months, its ability to keep up with the mad scientists on Wall Street is questionable.  For example, the mass marketing of risky structured products such as reverse convertibles, principal protected notes and auction rate securities was left unchecked.  Individual investors were not adequately informed as to the risk of these instruments and ended up bearing the brunt of their losses while Wall Street earned fat commissions.

Increased responsibilities for the SEC should help in this regard.  The SEC will require more transparency and improvement in the timing and quality of disclosures regarding securities products and will be required to perform “field tests” to ensure investors understand the risks.  Perhaps the most important SEC-related provision is the establishment of a fiduciary responsibility for broker-dealers offering investment advice and to “harmonize the regulation of investment advisers and broker-dealers.”

Where the Plan Falls Short

Improvements, however, need to be made in the enforcement area.  It’s great to have more stringent regulations, but if Wall Street is allowed to ignore them and pay pithy fines it’s worthless.  The President’s plan supports ramped up efforts to ban crooked brokers and advisors from the industry, but seems to ignore the fines.  As I’ve written before, fines have become the cost of doing business on Wall Street.  They are viewed the same way as expenses for travel, office supplies and client entertaining.  This cannot continue.

Fines for wrong doing, especially when the accusations involve individual investors, should be damaging.  The multi-billion dollar auction rate securities debacle could have been prevented if Wall Street was more effectively policed when in 2006 regulators found impropriety.  Not only do fines need to be larger, they need to be felt, which is why instead of coming out of the general litigation budget, fines levied with regard to frauds committed against retail investors should come out of the bonus pool.  This is especially important for financial institutions that have received federal funds of late.  To pay a fine using tax payer money adds insult to injury.

There are undoubtedly areas of improvement, but like many investors, I’m cautiously optimistic.

Is Supreme Court Justice Nominee Sonia Sotomayor a Champion of Individual Investors?

President Obama ended the speculation and nominated Judge Sonia Sotomayor of the United States Court of Appeals for the Second Circuit for the Supreme Court position left vacant by soon-to-be departed Justice David Souter. 

In Judge Sotomayor, the President has nominated what some consider an “activist” judge.  For me, that label doesn’t make a whole lot of sense because a judge’s job is to interpret the law.  Disagreeing with the status quo doesn’t necessarily make a judge an “activist” in my opinion.  

But more importantly, in Judge Sotomayor, are investors getting a champion of their rights?

Without a doubt, the current make-up of the Supreme Court has become far too business friendly and far too anti-investor.  Two of the most impactful decisions of late include “StoneRidge” and “Tellabs,” a one-two punch in the gut to investors which I have posted about often.  The Court is in desperate need of a voice that does not represent the interests of Corporate America.

Because the Second Circuit Court of Appeals’ jurisdiction includes Wall Street, it hears a large number of cases involving investors, so Judge Sotomayor has amassed a track record on investors-rights issues that we can study. Based on some of Judge Sotomayor’s rulings thus far, investors may have a fighting chance.

For example, in Dabit v Merrill Lynch, a securities class action involving state law securities claims Sotomayor reversed an earlier court decision and allowed Dabit to re-plead because it was “conceivable that claims based on wrongfully-induced holding could be pleaded.” The effect of Judge Sotomayor’s ruling would have been to allow the class action to go forward despite Merrill Lynch’s argument that federal law preempted plaintiffs’ ability to sue for securities violations under state law. Unfortunately, her decision was later reversed by the Supreme Court in a unanimous 8-0 decision. 

She also joined a 2-1 decision conferring class-action status in Visa Check, 280 F.3d 124 (2001), a class action brought by merchants challenging the fees that Visa and Mastercard charged for using their debit and credit cards. Judge Sotomayor ruled that “a motion for class certification is not an occasion for examination of the merits of the case.” The power of the Visa Check decision was later undermined by an amendment to the Federal Rules of Civil Procedure, though, and the Second Circuit - including Judge Sotomayor - has ruled that trial judges should make a more searching examination of the merits of a case when deciding whether to certify a class.

 Like most appellate judges with a long track record, Judge Sotomayor’s record on investors’ issues is mixed.  In a 2006 decision, In re IPO, 471 F.3d 24, she voted to decertify a class action alleging that big banks had manipulated the prices of tech-sector initial public offerings and collected huge fees from investors in connection with the manipulation.  The opinion reversed a lower-court ruling, raised a hurdle in front of investor classes trying to recover for investment banks’ wrongful conduct and scuttled a $1 billion settlement that had been reached.

 While there’s always the potential for her nomination to be derailed, certain aspects of Judge Sotomayor’s record provide a glimmer of hope for investors who have been thoroughly ignored by the Supreme Court.

Change at the SEC: A Question of Who and What

Throughout his two-year presidential campaign, President-elect Barack Obama’s constant theme was a promise of change.  And nowhere are we in more need of it than in the regulation of our capital markets.  Therefore his nominee to head the SEC is naturally a focal point.

The most recent names rumored include William Brodsky, CEO of the Chicago Board Options Exchange, former SEC Commission Harvey Goldschmid, AFL-CIO Associate General-Counsel Damon Silvers and Mellody Hobson, president of Ariel Capital Management.  Others include Robert Pozen, Fidelity Investments Vice Chairman Robert Pozen and FDIC director Martin Gruenberg.

And of course no list would be complete without the ubiquitous Goldman Sachs alum.  This time it’s Gary Gensler, a current partner that also served as a Treasury Department Undersecretary.

I’ve been on record advocating that President-elect Obama’s advisors need not look any further than among a deep bench of state regulators.  Candidates that immediately come to mind are New York State Attorney General Andrew Cuomo, Massachusetts Secretary of State William Galvin and Karen Tyler, North Dakota Securities Commissioner and former president of the North American Securities Administrators Association (NASAA).

These individuals have shown an understanding of sophisticated financial instruments as well as the ability to identify problems and put into action meaningful, lasting solutions.  They have also shown that investor confidence and securities enforcement are not mutually exclusive concepts.  And they have taken on Wall Street’s legions of highly paid lawyers - and won.

President-elect Obama’s nomination needs to send a message: that the industry serves the investors, not vice-versa.  Naming any of these individuals or someone similar would be change investors can believe in.

Perhaps a more instructive conversation is to examine the issues and how a future SEC chairman can approach them from an investor’s standpoint.

However the financial regulation structure is modeled, an investor czar should be appointed who is singularly focused on ensuring proper disclosure and protection for all products sold to retail investors.  If Wall Street wants to sell ”microwave ovens” (as Merrill Lynch described its push to unload illiquid auction rate securities), they need to be regulated as such.

In addition to a czar, enforcement needs to be overhauled.  Penalties for Wall Street firms have become just a cost of doing business.  Fines and suspensions need to become meaningful enough to prevent wrongdoing.  Overhauling the securities arbitration process is another must.  FINRA must eliminate the industry arbitrator to make securities arbitration fairer for investors.

An overarching theme for the incoming SEC chair should be transparency and disclosure.  More transparency is needed in the credit default swaps market and in hedge fund transactions in particular. The SEC should regularly have the ability to examine hedge fund holdings and leverage to determine systemic risks.

Given the destruction we saw in the financial equities market, new regulations regarding short selling are also in order.  I strongly believe a short seller should be required to own a security (and not just stocks given hedge funds short any number of instruments) he or she wants to short.  And the SEC should reinstitute the up-tick rule at least until a more comprehensive understanding of its affect is reached.

Wall Street has fundamentally changed over the past 12 months and regulatory oversight must adjust as well.  If ever there was a silver lining, a great many  hucksters have been forced out and no longer pose a threat.  That’s good news for the market and the SEC.  But the incoming SEC leaders still have a monumental task ahead.

I am confident that with the right person in place, afforded with the right powers, a new and improved financial market is in our future.