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News January 11, 2010 Issue

Investors’ Panel Says Financial Regulatory Reform Still Short of the Mark

The progress report is in, and at best, it looks like Congress is getting a C+.

At least according to the Investors’ Working Group, a watchdog panel created early last year by the CFA Institute and the Council of Institutional Investors. Improvements are still needed, they say, and investors’ interests are only being served in a few key areas so far.

Co-led by former SEC chairmen Arthur Levitt and William Donaldson, the IWG is packed with investor advocates such as Barbara Roper (Consumer Federation of America) and Jane Bryant Quinn (Bloomberg, Newsweek), former regulators such as Harvey Goldschmid (SEC) and Brooksley Born (CFTC), and industry representatives such as Mark Anson (Nuveen president) and Joe Dear (CIO of CalPERS). Over the course of the past year, the IWG developed recommendations for Congress that were issued on July 15, and that appear to have been incorporated at least in part in the current legislative efforts.

Now that Congress is a third of the way through the process, with a House version of regulatory reform approved, a Senate version pending, and a compromise yet to be hammered out between the two, the IWG has issued a progress report. It includes some seemingly provocative ideas about financial regulatory reform.

"Investors want significant upgrades to provisions relating to SEC funding, systemic risk oversight, over-the-counter derivatives, private fund regulation, nationally recognized statistical rating organizations (NRSROs), and corporate governance," said the IWG.

While praising the inclusion of a number of IWG-recommended changes in the House’s Wall Street Reform and Consumer Protection Act of 2009, the panel urged the Senate to go further as its Committee on Banking, Housing, and Urban Affairs begins to consider the draft Restoring American Financial Stability Act of 2009.

Here’s what the panel hopes to see in the final legislation:

SEC funding.

The House bill increases the SEC’s budget. The Senate discussion draft would provide the SEC with a self-funding mechanism. The IWG believes the SEC should have both stable long-term funding and a self-funding mechanism that maintains sufficient resources and enhances independence. Claiming that "on occasion, the Commission has shown reluctance to exercise its authority in certain areas out of fear of political budget retaliation," the IWG said the resulting "pockets of poor oversight proved to be sources of great risk." As a result, the IWG concluded that "[s]ufficient, stable, long-term funding that is removed from the Congressional appropriations process is critical to strengthening the independence and effectiveness of the SEC and would address one of the major contributing factors to the financial crisis."

Systemic risk oversight.

So far, said the IWG, Congress is looking to invest systemic risk oversight authority in the "same functional regulators who failed to prevent systemic failure in recent years." The IWG believes a level of independence is required, and has proposed a Systemic Risk Oversight Board (SROB), supported by an independent full-time staff and panel of experts to help it provide unbiased and informed perspectives on market risks.

Regulation of investment managers.

The House bill requires a single fiduciary standard for all financial professionals providing retail investment advice, but exempts from SEC registration those advisers to hedge funds with less than $150 million of assets under management. The Senate’s discussion draft would impose the adviser fiduciary standard on brokers by eliminating the broker/dealer exemption under the Adviser’s Act, and study whether a single fiduciary standard is feasible and beneficial.

To address these disparate approaches, the IWG is urging 100% registration of all advisers with the SEC. That’s right, all advisers, regardless of size or domicile. This, says the IWG, will serve investor interests and help the SROB monitor systemic risk issues more effectively. "The omission of a registration requirement may ultimately delay the kind of true market reform that investors want," said the panel.

OTC derivatives.

The House and Senate provisions are closely aligned, said the IWG. In both cases, a potentially large number of derivative transactions, including certain swaps, would remain exempt from exchange-trading and central-clearing requirements. The customized instruments that benefit from these exemptions would, at best, only have to report on their pricing to a swap repository.

The IWG, in response to investors’ concerns about the lack of oversight and controls for many customized derivatives, believes there should be only very limited exceptions to the requirement for all standardizable contracts to be exchange-traded and centrally cleared. The IWG is urging the Senate to take a more comprehensive approach to federal oversight of all derivatives, one that includes enhanced transparency and capital requirements for derivative activities.

NRSRO oversight.

The IWG acknowledged House and Senate efforts to include important provisions such as increased internal controls, greater transparency of rating procedures and methodologies, greater enforcement tools, and SEC examination of NRSROs.

However, the panel would like to see the Senate adopt a provision that is currently only in the House bill. That provision would subject credit rating agencies experts to Securities Act liability when their ratings are included in a registration statement, similar to liability currently imposed on accountants and other parties. "We believe this provision would make rating agencies more diligent about the ratings process and, ultimately, more accountable for sloppy performance," said the IWG. As the discussion draft is improved, we are hopeful that the Senate will incorporate this valuable provision in the legislation.

Corporate governance.

Finally, the IWG believes the House bill and the Senate’s discussion draft "appropriately" amend the federal securities laws to affirm the SEC’s authority to promulgate rules allowing shareowners to place their nominees for directors on the company’s proxy card. They believe the House bill is deficient, however, in that it fails to require the election of directors by a majority of the votes cast.

"A uniform proxy access rule is necessary to effectuate shareowners’ fundamental right to have the ability in appropriate circumstances to place their nominees for director on companies’ proxy cards," said the panel.

The IWG also believes it is critical that any regulatory reform legislation also include a provision requiring that directors be elected by a majority of the shareowner votes cast. Such a provision would help eliminate "rubber stamp" elections that effectively prevent shareowners from removing those directors that fail to fulfill their oversight responsibilities.

"Both the reaffirmation of SEC authority and majority-voting provisions provide investors with basic tools to better hold corporate officers accountable for their actions," said the panel, "a necessary component of any effective reform of the U.S. financial regulatory system.