Chairman Gramm, Senator Sarbanes, and Members of the Committee:
I appreciate the opportunity to testify on behalf of the Securities and Exchange Commission ("SEC" or "Commission") regarding financial modernization legislation. I am pleased to appear before this Committee again to present the Commission's views on this important issue.
The Commission has long supported the goal of modernizing the legal framework governing financial services. As we work toward this goal, however, we must also preserve principles that are fundamental to effective oversight of the U.S. securities markets. Our securities markets today are strong, vibrant, and healthy. They are relied on by both individual investors who are increasingly putting their savings in stocks, bonds, and mutual funds(1)
and by American businesses that need to raise capital.(2)
The success of our securities markets is based on the high level of public confidence inspired by a strong system of investor protection, and on the entrepreneurial and innovative efforts of securities firms. As the nation's primary securities regulator, it is critical that the Commission be able to continue to fulfill its mandate of investor protection and to safeguard the integrity, fairness, transparency, and liquidity of U.S. securities markets.
The Commission has reviewed the staff discussion draft of financial modernization legislation that the Senate Banking Committee released last week. Unfortunately, I believe that, in its current form, the bill runs the risk of dramatically undermining investor protection and the integrity of U.S. securities markets. The Commission understands that the discussion draft is very much a work-in-progress, but it cannot possibly support the discussion draft in its current form.
By repealing provisions of the Glass-Steagall Act without removing the bank exemptions from federal securities laws, this draft bill would create a dangerously bifurcated system of regulation. A significant portion of securities activities would take place outside the protections of the securities laws. The bank exemptions to federal securities law were, in part, premised on the very existence of the barriers that the Glass-Steagall Act had erected. For the sake and safety of our capital markets, we should not contemplate removing outdated restrictions without also removing outdated exemptions.
The Commission has outlined below five points it feels should be addressed by any financial modernization bill. Specifically, it is crucial that the Commission retain supervisory and regulatory authority over the U.S. securities markets, regardless of where securities activities are conducted. The Commission believes that the following are critical safeguards in any financial modernization legislation:
These objectives are not novel; they have been central themes to all of the Commission's testimony to date. We believe these objectives can be addressed in a variety of ways -- and certainly in significantly fewer pages than in previous versions of H.R. 10 -- but they are nonetheless important to investors and the continued success of our markets.
We recognize and appreciate the Committee's attempt to streamline the draft bill. In keeping
with this pared-down approach, we believe that we can offer a simple way to make the discussion
draft's provisions relating to the securities industry consistent with sound public policy. You
could, along with repealing section 20 of the Glass-Steagall Act, also repeal the existing
exemptions from the federal securities laws for bank broker-dealer and bank investment adviser
activities. This would preserve and strengthen investor protections and the vitality of U.S.
securities markets. The Commission cannot ensure the integrity of U.S. markets if it is only able
to supervise a portion of the participants in those markets. Neither can it ensure fair and orderly
markets if market participants operate by different rules and investors receive different levels of
The Commission is eager to work with the Committee to achieve an appropriate balance in financial modernization legislation, without compromising these important principles.
II. Background on the Securities Activities of the Banking Industry
Before discussing the Commission's objectives in detail, I would like to summarize the key points that the Commission has consistently raised in considering Glass-Steagall reform.
The Commission has been the nation's primary securities regulator for 65 years. As such, it is
the most experienced and best equipped to regulate securities activities, regardless of who
conducts those activities. The Commission's statutory mandate focuses on investor protection,
the maintenance of fair and orderly markets, and full disclosure. Moreover, securities regulation
encourages innovation on the part of securities firms, subject to securities capital requirements
that take into account risk-taking activities. Significantly, securities regulation -- unlike banking
regulation -- does not protect broker-dealers from failure. It relies on market discipline, rather
than a federal safety net, with an additional capital cushion and customer segregation
requirements to insulate customers from the losses of broker-dealer firms. Moreover, protection
of customer funds has been further assured by the Securities Investor Protection Corporation
This Committee is well aware of the many securities activities in which the banking industry now engages. While these market developments have provided banks with greater flexibility and new areas for innovation, they have also left U.S. markets and investors potentially at risk. Because banks have, to date, retained their exemptions from most federal securities laws, their securities activities have been governed in a hodge-podge manner by banking statutes and regulations that have not kept pace with market practices or needs for investor protection. As you know, banking regulation properly focuses on preserving the safety and soundness of banking institutions and their deposits, and preventing the failure of banks. But, because market integrity and investor protection are not principal concerns of banking regulation, the Commission believes that banking regulation is not an adequate substitute for securities regulation. Thus, it is crucial that any financial modernization legislation include a repeal of the bank exemptions from federal securities law.
In order for banks to be fully liberated from the outdated Glass-Steagall Act restrictions on their ability to conduct securities activities, banks must be willing to take on the responsibility for full compliance with U.S. securities laws, with which all other securities market participants must comply. As discussed more fully below, failure to impose such responsibility on banks would undermine the current safeguards and investor protections contained in the federal securities regulatory scheme and would threaten the vitality of U.S. securities markets. The Commission would vigorously oppose any final legislation that does not require bank compliance with federal securities laws.
III. Commission Objectives for Financial Modernization
I will now turn to a more detailed discussion of the fundamental securities principles that the Commission believes are necessary elements of a truly effective financial modernization bill.
A. Aggressive SEC Policing and Oversight of All Securities Activities
Public confidence in our securities markets hinges on their integrity. As the Supreme Court recently stated: "an animating purpose of the Exchange Act . . . [is] to insure honest securities markets and thereby promote investor confidence."(5)
The Commission has an active enforcement division, whose first priority is to investigate and prosecute securities fraud. The banking regulators, on the other hand, are required to focus their efforts on protecting the safety and soundness of banks, which does not consider the interests of defrauded investors. Detecting securities fraud is a full-time job, and it is a far cry from formulating monetary policy.
To continue its effective policing and oversight of the markets, the Commission must be able to monitor all securities activities through regular examinations and inspections, which includes access to all books and records involving securities activities. This unfettered access is currently not available. For example, during recent examinations of bank mutual funds, Commission examiners have had difficulty gaining access to key documents concerning the securities advisory activities of banks.(6)
The Commission cannot vigorously protect the integrity of U.S. markets and adequately protect investors with one hand tied behind its back.
B. SEC Financial Responsibility Rules for All Securities Businesses
Securities positions can be highly volatile. The Commission's capital requirements recognize this fact and are, with respect to protection from market risk, more rigorous than those imposed by bank regulators. Market exposures and volatility are risks that the net capital rule was designed to address, unlike bank capital requirements, which focus more on credit exposure. Thus, the Commission's net capital rule better protects the liquidity of any entity engaging in often volatile securities transactions.
In addition to promoting firm liquidity, the Commission's net capital rule is a critical tool to protect investors and securities markets because the Commission can also use the net capital rule to address abusive or problematic practices in the market. For example, with respect to penny stock market makers, the Commission can limit their activity by raising capital requirements for market-making activities. In addition, the Commission can expand on the margin rules with respect to particularly risky stocks by increasing capital charges. Finally, the net capital rule's 100-percent capital charge for illiquid securities serves to maintain orderly markets in securities that have no liquidity or transparency. Without the ability to uniformly apply its net capital rule, the Commission's ability to oversee and influence U.S. securities markets is severely inhibited.
In addition to detailed net capital requirements that require broker-dealers to set aside additional capital for their securities positions, the Commission's customer segregation rule prohibits the commingling of customer assets with firm assets. Thus, customer funds and securities are segregated from firm assets and are well-insulated from any potential losses that may occur due to a broker-dealer's proprietary activities.
Because the Commission's financial responsibility requirements are so effective at insulating customers from the risk-taking activities of broker-dealers, the back-up protection provided by SIPC is seldom used. Although there have been broker-dealer failures, there have been no significant draws on SIPC, and there have been no draws on public funds. In fact, because of the few number of draws on SIPC funds, SIPC has been able to satisfy the claims of broker-dealer customers solely from its interest earnings and has never had to use its member firm assessments to protect customers. This is in sharp contrast to the many, often extensive, draws on the bank insurance funds to protect depositors in failed banks. In addition, during recent market turmoil in the financial markets, SEC-regulated entities were well-collateralized and none was ever at risk of failure.
We must continue to protect our markets from systemic risk by ensuring that there is enough capital to support the market risk that is inherent in securities transactions. In addition, we must ensure that customer funds and securities are fully protected by enforceable requirements to segregate customer assets from firm assets. To satisfy its quest for effective financial modernization, Congress should permit the Commission to set financial responsibility requirements for all securities activities, in order to better protect investors and U.S. markets.
C. SEC Sales Practice Rules Applied to All Securities Activities
All investors deserve the same protections regardless of where they choose to purchase their securities. Unfortunately, gaps in the current bifurcated regulatory scheme leave investors at risk. For example, broker-dealers are subject to a number of key enforceable requirements to which banks are not, including requirements to:
adequately supervise all employees.(7)
Investors are generally not aware of these gaps in regulation and the risks that such gaps create.
In addition, federal banking statutes do not provide customers a private right of action for meritorious claims, and banking regulators do not routinely fully disclose the details of any and all enforcement and disciplinary actions against banks to put customers on alert. Although some customer protections have been suggested by the bank regulators, they are less comprehensive than the federal securities laws and serve to perpetuate the disparities between the bank and securities regulatory schemes.
Some have suggested a system of parallel securities regulation by the banking regulators. However, the Commission notes that the 12(i) model for parallel regulation of bank issuer reporting has not achieved the objectives of the federal securities laws. Under section 12(i) of the Securities Exchange Act,(8)
banking regulators are required to adopt rules "substantially similar" to the Commission's rules within 60 days after the Commission's publication of its final rules. Notably, one commentator has stated that "final action by the [banking] regulators in promulgating 'substantially similar' 1934 Act rules has been delayed in some cases over five years after pertinent SEC amendments have been issued."(9)
In addition, promulgation of rules alone is not sufficient; banking regulators must also examine for compliance with any parallel regulatory requirements and take appropriate enforcement action when violations have occurred. The 12(i) model perpetuates a complex scheme of disparate rules offering different protections for investors and markets and different levels of enforcement efforts.
I would like to briefly discuss two recent Commission enforcement actions that highlight the need for more universal application of strict sales practices rules to all entities engaged in securities activities.
In the first case, the Commission is alleging that the portfolio manager of two money market mutual funds sponsored by a bank (i) caused the funds to purchase volatile derivative instruments, (ii) fraudulently transferred the derivatives at inflated values between the mutual funds to some of the bank's various trust accounts to cover up the mutual funds' losses, and (iii) ultimately caused the funds to "break the buck." The Commission investigated and has initiated enforcement action against the mutual fund's portfolio manager.(10)
However, because of the current bank exemptions from federal securities law, the Commission was unable to bring charges against the bank or its personnel for failing to adequately supervise the fund manager. Under these facts, the Commission ordinarily would have brought charges against any of its regulated entities for similar misconduct, and the Commission considers its ability to bring "failure to supervise" claims to be critical to investor protection. Securities fraud of this type -- where transactions occur both in mutual funds and in bank trust accounts -- illustrates the need for securities regulators to have access to books and records involving all securities activities conducted by banks.
In the second case, employees of a bank and its broker-dealer affiliate blurred the distinction between the two entities and their respective products during sales presentations to customers and in marketing materials.(11)
In addition, the bank created an environment where the broker-dealer's employees could mischaracterize certain products as bank-like conservative investments when, in fact, they were highly leveraged funds that invested in interest-rate-sensitive derivatives. These actions resulted in customers, many of whom were elderly and thought they were purchasing investments in stable government bond funds, making unsuitable purchases of high-risk funds. The case is also evidence of how partial securities regulation split between banks and their securities affiliates is inadequate to fully protect investors.
The Commission believes that the protections provided by the high, uniform standard of the federal securities laws should benefit all investors purchasing securities.
D. Uniform Mutual Fund Adviser Regulation and Conflict-of-Interest Rules
Mutual fund investors should always receive the protection of the federal securities laws. Accordingly, all parties that provide investment advice to mutual funds should be subject to the same oversight, including Commission inspections and examinations. In addition, any type of entity that is affiliated with a mutual fund should be subject to the strict conflict-of-interest provisions of the federal securities laws.
For these reasons, the Commission supports what appear to be non-controversial provisions of previous versions of financial modernization legislation that would address the increasing involvement of banks in the mutual fund business and would reduce potential conflicts of interest. We suggest adding similar language to the draft bill that this Committee is currently considering in order to fully protect mutual fund investors by providing for full bank compliance with the federal securities laws with respect to their mutual fund advisory activities.
Banks that act as investment advisers currently enjoy an exemption from the registration and other requirements of the Investment Advisers Act of 1940. As a result, bank investment advisers are not subject to the substantive requirements applicable to registered investment advisers, including: (i) regulation of advertising, solicitation, and receipt of performance fees; (ii) procedures to prevent misuse of non-public information; (iii) books and records and employee supervision requirements; and (iv) the general anti-fraud provisions.
In addition, as banks increasingly advise mutual funds, the Commission grows more concerned that its examiners do not have ready access to information regarding bank advisory activities that could affect bank-advised mutual funds. Such access is necessary in order to detect front-running, abusive trading by portfolio managers, and conflicts of interest (involving, for example, soft-dollar arrangements, allocation of orders, and personal securities transactions by fund managers). For example, as part of its review for conflicts of interest with respect to a bank mutual fund adviser's activities, Commission examiners must be able to compare trading activity in a mutual fund portfolio to that in the bank's trust accounts. As discussed above, the Commission has had difficulty obtaining full access to all relevant information when reviewing the securities activities of banks that advise mutual funds.(12)
The Commission must be able to review records relating to all securities activities relating to mutual fund advisers, just as it does for non-bank fund advisers.
The Commission is also concerned about the unique conflicts of interest resulting from increased bank involvement in the mutual fund business. Currently, the Investment Company Act of 1940 places restrictions on certain transactions between investment companies and their affiliates. These restrictions were crafted, however, at a time when Congress could not have anticipated the dramatic change in the scope of bank securities activities. Specifically, the Commission is concerned about conflicts of interest that may arise from:
E. Voluntary Broker-Dealer Holding Companies
In order to expand overseas, U.S. broker-dealer firms generally must demonstrate to foreign regulators that they are subject to comprehensive supervision on a worldwide basis. Thus, the Commission strongly supports the ability of U.S. broker-dealers to voluntarily subject their activities to Commission supervision on a holding company basis. The Commission's "umbrella" oversight would be based on a risk-supervision model that more appropriately reflects the predominant risk-taking securities activities of the consolidated entity. Of course, any regulated subsidiaries of a broker-dealer holding company would continue to be regulated by the appropriate statutory regulator.
The Commission believes that a supervisory framework for holding companies substantially engaged in securities activities would permit securities firms the flexibility to innovate and keep pace with the rapid changes in today's capital markets. This structure would impose risk-based supervision, consistent with the firm's principal business, and would help protect market integrity by ensuring that there are no supervisory gaps.
The Commission has testified many times during the past decade in support of financial modernization.(13)
However, the legislation as currently drafted perpetuates the broad bank exemptions from federal securities law regulation. This runs the risk of grievously threatening market integrity and the continued strong growth we have seen in the U.S. securities markets.
In the debates surrounding this issue, the Commission's primary concerns have been the protection of the integrity of U.S. markets and those who invest in them. Unfortunately, the bill as currently drafted would prevent the Commission from effectively carrying out its statutory mandates, and we could not support such legislation.
The Commission encourages all involved to step back and look at the securities issues arising out of financial modernization with a fresh perspective. We must not lose sight of basic securities law protections and goals, which have served to ensure that the U.S. markets are the fairest, safest, most vibrant, most transparent, and most liquid markets in the world.
We thank you for offering the Commission the opportunity to present its viewshere today. I
would be happy to answer questions that you may have.
1 As of December 1998, mutual fund assets totaled $5.5 trillion. Investment Company Institute, Trends in Mutual Fund Investing: December 1998 (Jan. 28, 1999).
2 In 1998, businesses raised a record $1.8 trillion from investors, $1.31 trillion in 1997, and $967 billion in 1996. (These figures include firm commitment public offerings and private placements and do not include best efforts underwritings.) Securities Data Corporation.
3 The Commission recognizes that some bank securities activities may not give rise to the same investor protection, market integrity, and fairness concerns. One simple way to address this issue would be to provide clear authority for the Commission to exempt these activities, in consultation with the banking regulators. However, the Commission has previously stated in Congressional testimony that it could not support "a labyrinth of complicated, technical exemptions from federal securities law regulation." See, Testimony of Harvey J. Goldschmid, General Counsel, U.S. Securities and Exchange Commission, Concerning H.R. 10, the "Financial Services Act of 1999," Before the House Comm. on Banking and Financial Services (Feb. 12, 1999).
4 SIPC is a non-profit membership corporation created by the Securities Investor Protection Act of 1970. SIPC membership is required of nearly all registered broker-dealers, and SIPC is funded by annual assessments on its members. If a broker-dealer were to fail and have insufficient assets to satisfy the claims of its customers, SIPC funds would be used to pay the broker-dealer's customers (up to $100,000 in cash, and $500,000 in total claims, per customer).
5 United States v. O'Hagan, 521 U.S. 642, 117 S.Ct. 2199, 2210 (1997).
6 The Commission and the federal bank regulatory agencies have worked to enhance coordination of their examination and inspection programs. See Testimony of Lori Richards, Director, Office of Compliance Inspections and Examinations, U.S. Securities and Exchange Commission, Concerning the Securities and Exchange Commission's Examination Oversight of Securities Firms Affiliated with Banks, Before the Subcomm. on Financial Institutions and Consumer Credit, House Comm. on Banking and Financial Services (Oct. 8, 1997). Despite these initiatives, however, the Commission continues to have difficulty obtaining access to all appropriate books and records.
7 The federal bank regulatory agencies have issued guidelines that address some bank sales practice issues. See Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision, "Interagency Statement on Retail Sales of Nondeposit Investment Products" (Feb. 15, 1994). These guidelines are advisory and therefore not legally binding, and they may not be legally enforceable by bank regulators.
8 15 U.S.C. 78l(i).
9 Michael P. Malloy, The 12(i)'ed Monster: Administration of the Securities Exchange Act of 1934 by the Federal Bank Regulatory Agencies, 19 Hofstra L. Rev. 269, 285 (1990).
10 See In the Matter of Michael P. Traba, File No. 3-9788, Release No. 33-7617 (Dec. 10, 1998).
11 In the Matter of NationsSecurities and NationsBank, N.A., Release No. 33-7532 (May 4, 1998).
12 See note 6 and accompanying text above.
13 See, e.g., Testimony of Harvey J. Goldschmid, General Counsel, U.S. Securities and
Exchange Commission, Concerning H.R. 10, The "Financial Services Act of 1999,"
Before the House Comm. on Banking and Financial Services (Feb. 12, 1999); Testimony
of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning
H.R. 10, The "Financial Services Act of 1998," Before the Senate Comm. on Banking,
Housing, and Urban Affairs (June 25, 1998); Testimony of Arthur Levitt, Chairman, U.S.
Securities and Exchange Commission, Concerning Financial Modernization and H.R. 10,
the "Financial Services Competition Act of 1997," Before the Subcomm. on Finance and
Hazardous Materials of the House Comm. on Commerce (July 17, 1997); Testimony of
Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning
Financial Modernization, Before House Comm. on Banking and Financial Services
(May 22, 1997); Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange
Commission, Regarding H.R. 1062, the "Financial Services Competitiveness Act of
1995," Before the Subcomm. on Telecommunications and Finance and the Subcomm. on
Commerce, Trade and Hazardous Materials of the House Comm. on Commerce (June 6,
1995); Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange
Commission, Concerning the "Financial Services Competitiveness Act of 1995" and
Related Issues, Before the House Comm. on Banking and Financial Services (Mar. 15,
1995); Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange
Commission, Concerning H.R. 3447 and Related Functional Regulation Issues, Before
the Subcomm. on Telecommunications and Finance of the House Comm. on Energy and
Commerce (Apr. 14, 1994); Testimony of Richard C. Breeden, Chairman, U.S. Securities
and Exchange Commission, Concerning Financial Services Modernization, Before the
Subcomm. on Telecommunications and Finance of the House Comm. on Energy and
Commerce (July 11, 1990); Memorandum of the Securities and Exchange Commission
(under Chairman David Ruder) to the Subcomm. on Telecommunications and Finance of
the House Comm. on Energy and Commerce, Concerning Financial Services
Deregulation and Repeal of the Glass-Steagall Act (Apr. 11, 1988); Testimony of David
S. Ruder, Chairman, U.S. Securities and Exchange Commission, Concerning the
Structure and Regulation of the Financial Services Industry, Before the Subcomm. on
Telecommunications and Finance of the House Comm. on Energy and Commerce (Oct. 5,
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