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.

The Paulson Plan…2.0

Two years ago, if you mentioned “The Paulson Plan,” you would be referring to Wall Street’s attempt to further deregulate themselves under the cloak of patriotism.

“We need less rules or else America will be less competitive,” they told us.

Today, we are again debating “The Paulson Plan,” and indeed, America’s competitiveness is at stake but this time, universally it is acknowledged that Wall Street’s unbridled greed put us here in the first place.  Secretary Paulson, with his $500 million Goldman Sachs pedigree, is unarguably a member of the club.

And so at this juncture, I believe it is appropriate that we ask ourselves, can we trust this man with a trillion dollar blank check when he’s singing such a different tune on regulatory reform?  Mind you, this is not a critique of the band-aid solutions Secretary Paulson has orchestrated to date - that’s what history books are for - but rather hand raised on behalf of investors.

As an investor advocate, I see nothing in this bail-out that addresses the systematic fraud that was committed against investors.  As I’ve written about before, many investors are still holding distressed securities that were pitched to them as cash equivalents, conservative long term securities and any number of other ways contrary to the truth. Therefore, as a condition to unloading toxic debt onto the taxpayers - as is The Paulson Plan 2.0 - Wall Street should be required to make their customers whole.  Whether its an investor that bought auction rate securities, Citigroup’s ELKS (derivatives), short-term bond funds, preferred stock of financial firms, hedge funds or whatever the case may be, if an investor was mislead they should get their money back.

Frankly, it’s shameful that investor protection is even still an issue after the tech-bubble destroyed millions of investors’ net worth.  The systemic problem can be summed up in an email uncovered from a Merrill Lynch executive as she prodded her brokers to sell more auction rate securities: “Let’s move these microwave ovens!!!” she said.

Well, if Wall Street considers its products like microwave ovens, then they deserve to be regulated as such.  Which is why I subscribe to the idea of a consumer protection agency for investors.  As Yale professor and predictor of the real estate bubble Robert Shiller suggests, the financial services industry should be “democratized.”  He recommends a consumer advocate akin to the Consumer Products Safety Commission to look after the little guy, ensure disclosures are prominent and clear, and perhaps most importantly identify inherent conflicts of interests.

I hear the cat calls…what about the SEC?  Isn’t that what they are there for?

The SEC was created in 1934 as a result of the stock market crash of 1929.  Given its performance since then, it’s only fitting that it should be replaced as the guardian of the individual investor in the midst of the greatest financial disaster since those dark days.

It’s also no coincidence that the phrase “white-collar crime” was coined during the Great Depression.  In the aftermath of every financial crisis, there are those that have paid the price for their roles.  This was true during the S&L crisis and the dot-com bubble. Similar fallout is justified today.

So a little comeuppance is in order for the Wall Street’s C-suite executives that either knowingly or unknowingly stuck their head in the sand while the American financial system was destroyed.  Lehman Brothers, for example, should not get a free pass for the rosy assessment of its balance sheet and for saying that short-seller David Einhorn’s comments about their valuations “had no basis in fact.”

Simply put, I’m not comfortable with the fact that financial services industry executives who have put the United States in grave danger should only have net-worths of $5 million instead of $500 million.  It would be one thing if these individuals put their own money at stake - something entrepreneurs should receive tax incentives for doing - but these people gambled with other people’s money and lost.

Its sometimes said that the best way to rob a bank is to own one.  Wall Street did that and much, much more.

Finally, there’s a lot of discussion about executive compensation on Wall Street.  You won’t get an argument from me that its out of control, but socializing incentives sets an awfully distressing precedent.  Rather, as I’ve advocated before, Wall Street should be compensated over prolonged periods during which time it can be assessed whether their performance had long-term benefit to shareholders.  Brokers and the mad-scientists behind the structured products movement would be measured according to how many customers filed arbitration cases.  Investment bankers would be held accountable for the client’s performance after an M&A transaction.  And CEOs would have to show sustained increases to shareholder’s equity.

These considerations arguably are only the beginning.  So again let’s ask ourselves, is the former CEO of Goldman Sachs who we want crafting the biggest financial bail-out in history?