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Regulation and Compliance > Federal Regulation > SEC

Stretched Too Thin?

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No single commercial or governmental agency has as big an influence on financial planners and investment advisors as the Securities and Exchange Commission. Moreover, within the past few years, the SEC has been given increased regulatory responsibilities and the budget to accommodate those duties. Despite the added staff and money, however, some have questioned how well the Commission is performing its primary job of protecting the investing public and the markets, and worry that the SEC has become dangerously overextended. Since its commissioners are presidential appointees, there is also concern over the role of politics in its actions and priorities.

There is no doubt that the SEC is at a critical juncture. Not only did two of its top officials–Paul Roye and Stephen Cutler–recently resign within a month of each other, but the securities regulator will also lose one of its commissioners, Harvey Goldschmid, at the end of July. A Democrat, Goldschmid has voted with SEC Chairman William Donaldson and fellow Democratic commissioner Roel Campos to enact two very contentious rules–the mutual fund independent director rule, and hedge fund manager registration–both of which are being challenged in court. Goldschmid’s departure shifts the political winds at the Commission, opening up the possibility of two-two votes that could trigger a regulatory stalemate. The Financial Planning Association is also suing the SEC over its recent decision to exempt brokers from having to comply with the Investment Advisers Act of 1940 (see News story, page 19). In addition, rumors are circulating that Donaldson will abandon his post by the end of the year. Then there is the question, raised by Goldschmid himself, of whether the regulator has adequate funding and staff to do its job.

Roye, who had headed the SEC’s Division of Investment Management since 1998, left the post in March. He was instrumental in helping the Commission craft a number of regulations in 2004 to address the mutual fund trading scandal, as well as the rule requiring investment advisors to have a chief compliance officer. In May, Roye joined Capital Research & Management Co., the parent company of the American Funds mutual fund group, as a senior VP. Cutler, who stepped down from his post as chief of the Division of Enforcement in May, brought an unprecedented number of enforcement actions against corrupt mutual fund and hedge fund firms over the past few years. Why did Roye and Cutler decide to abandon ship almost simultaneously? Industry observers say both felt it was just their time to go. Neither job is “one that you want to do forever,” says Mercer Bullard, president and founder of Fund Democracy in Oxford, Mississippi, and a former SEC official. Besides getting tired of government salaries, “there is just too much work–particularly in enforcement; It’s a 24-hour job,” says Bullard, who was assistant chief counsel in the SEC’s Division of Investment Management from 1996 to January 2000. “You start to develop tunnel vision.”

Linda Chatman Thomsen, deputy director of the enforcement division, was appointed to fill Cutler’s spot in May. “From all indications, she’s highly competent,” says Geoff Bobroff, an independent consultant to the mutual fund industry. Meyer “Mike” Eisenberg, the SEC’s deputy general counsel, has been named as interim replacement for Roye. Eisenberg stressed that he is just the “acting” director of the division during testimony before the House Financial Services Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises last month. Finding a permanent replacement for Roye is proving to be a tough task. Bullard of Fund Democracy says potential candidates have been rejecting offers they’ve gotten from Donaldson to fill Roye’s spot. Folks are wary of taking the position because they don’t want to be on the job “for five months and [then] be out on the street again,” he says. This could be a sure sign that Donaldson is considering an exit. “I can’t see Donaldson lasting that much longer,” adds Bobroff. “With all the angst he’s had to go through, I’m surprised he’s still there.” If Donaldson does go, who will replace him? “Atkins appears to be lobbying for the job, and he’s far more conservative than Donaldson,” Bobroff says, referring to Paul Atkins, who was appointed commissioner by President Bush in July 2002; in the early 1990s, Atkins served on the staffs of former SEC chairmen Richard Breeden and Arthur Levitt.

David Tittsworth, executive director of the Investment Adviser Association in Washington, says replacing Roye is yet another thorn in Donaldson’s side. Donaldson’s “under pressure now,” he says. “The business community is out to bag him, there are lawsuits” against the SEC, and there were three recent “contentious votes” where the two Republican commissioners, Atkins and Cynthia Glassman, voted against Donaldson, Campos, and Goldschmid. “It’s a real contentious environment.”

Campos’s term expires this summer, but he’s going to be reappointed. Goldschmid, however, is returning to Columbia Law School at the end of July, which creates a two-two Commission in terms of party affiliation. Maintaining a two-to-two vote possibility is an ideal way to keep the Commission “from becoming too activist,” Tittsworth says. There’s even speculation that President Bush will take his time replacing Goldschmid for exactly this reason, Tittsworth adds. Indeed, Bobroff says the mutual fund industry would welcome a “quieting down” on the regulatory front. “A do-nothing Commission might be viewed as a positive in the sense that the mutual fund and asset management industries are struggling to cope with all of the new proposals, plus all of the new issues that are surfacing via the [SEC] inspection process,” he says.

Paul Schott Stevens, president of the Investment Company Institute (ICI), the mutual funds trade group, told the House Financial Services Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, on the same day in May that Eisenberg testified, that the SEC failed to conduct “rigorous” cost/benefit analyses before implementing its mutual fund reforms. Eisenberg shot back in his testimony, however, that “cost/benefit analyses should not be used to undermine regulatory initiatives.”

Contentious Rules

A two-two vote scenario becomes even more troublesome if, for instance, either the SEC’s rule requiring mutual fund boards to have an independent chairman and 75% independent directors, or the hedge fund registration rule, gets reversed in the near term, notes Bobroff. “What does the Commission do [if those rules are reversed] when Goldschmid is only going to be there until the end of July?” The U.S. Chamber of Commerce is suing the SEC over the fund independent director rule, which most fund firms must comply with by January 16, 2006. An independent hedge fund firm is suing the SEC over its rule requiring hedge fund advisors to register by February 2006.

The trouble with the independent directors rule is that it gives non-interested directors “management of everything the fund does,” Barry Barbash, a partner with the law firm Shearman & Sterling told Congress the same day that Stevens and Eisenberg testified. Barbash, a former director of the SEC’s Division of Investment Management, said that he also fears the abundance of new SEC regulations “may result in an unfortunate shift of focus away from directors’ core duties under the Investment Company Act of 1940, such as monitoring conflicts of interest, and instead mire directors in a sea of details pertaining to mundane and routine approvals best reviewed by management.” The increasing workload being placed on fund boards of directors is only exacerbated by “informal statements made by some SEC staff members suggesting that the Commission should and will increase the number of enforcement actions against independent directors of funds,” Barbash told Congress.

Following the revelations of market timing and late trading, the SEC implemented a number of rulemakings, including the hard 4:00 PM close rule to address late trading, the redemption fee rule, and the point-of-sale disclosure rule. Meyer Eisenberg told Congress in his testimony that he expects the hard 4:00 PM close rule–which would require fund orders to be received by the fund, its transfer agent, or clearing agency by 4:00 PM Eastern Standard Time–to be finalized this year. Eisenberg said SEC staff is now considering potential “technological solutions” that can be used to address late trading. “Chairman Donaldson has instructed staff to take the time necessary to fully understand the technology issues associated with any final rule,” he told Congress.

In March, the SEC voted to institute a voluntary 2% redemption fee on mutual fund shares sold within seven days of purchase. Bobroff says the voluntary ruling is “still ruffling feathers” because it’s not “being consistently applied.” Before the SEC ruling, fund boards could voluntarily choose to implement a redemption fee. Stevens of ICI told Congress that while a redemption fee is an important tool in protecting long-term fund shareholders from the harmful costs of short-term trading, the ruling is a perfect example of the SEC’s failure to perform a cost/benefit analysis. To comply with the rule, “funds will have to first identify the universe of their ‘intermediaries’ and then either modify any existing agreements or enter into new agreements containing terms required by the rule,” Stevens told Congress. Just identifying these intermediaries, he said, “will be substantially greater than the total time and cost the SEC estimates.” For instance, Stevens said, three large fund firms “estimate that in the aggregate they have over 6.5 million accounts that could be considered to be held by an intermediary for purposes of the rule.” Given the number of accounts that will have to be examined, he said, “the SEC’s estimate that the entire contract requirement can be satisfied in 4.5 hours of work per fund is completely unreasonable.”

POS Problems

Yet another SEC rule that’s drawing the ire of the mutual fund and brokerage industries is the point-of-sale disclosure rule. Eisenberg told Congress that the rule should be finalized by the end of 2005. The proposal would require brokers to disclose to investors–first at the point of sale and then at the completion of the transaction in the confirmation statement–enhanced information about the fees they’re being charged, as well as any conflicts of interest the broker may have. The main sticking point with the proposal is that the point-of-sale disclosure only applies to the sale of three types of securities–investment companies with mutual funds, variable insurance products, and 529 programs, Bobroff explains. “That means if I’m a broker, if I sell any one of those three [products], I’ve complicated my sales process,” he says. “But if I sell anything else, I don’t have any encumbrances. So the natural inclination of the broker is going to be to sell something else.” In addition, the Commission hasn’t decided how the delivery of these types of disclosures will occur. “Will it have to be at the point of sale? Could it be in advance via the Internet?” Bobroff asks. “There are lots of questions yet unanswered that are still very real in terms of the relative impact on the overall sales process for an industry.”

Another worry, says Bobroff, is whether the point-of-sale proposal as well as the hard 4:00 PM close proposal will go before the SEC commissioners for consideration while Goldschmid is still there. If Goldschmid leaves before the proposals are considered, and there’s a possibility of a tie vote among the commissioners, that could “mean nothing gets done,” he says.

Mutual fund-related initiatives that are “on the horizon,” Eisenberg told Congress, include measures to improve disclosure of mutual fund transaction costs, the use of soft dollars for research, the future of 12b-1 fees, and mutual fund disclosure reform. Findings from the SEC commission that was assigned to review the soft dollar issue should be available shortly, he said.

Enough Money and People?

An issue that has plagued the SEC for decades is whether it has adequate funding and staff to fulfill its oversight obligations. The SEC actually asked for less money in 2006 than it was awarded in 2005. The Administration’s FY 2006 budget for the SEC is $888 million, slightly less than the SEC’s $913 million budget for 2005. According to an ICI release, the SEC asked for less money in 2006 because the Commission spent less than anticipated in FY 2005. In an April speech, Goldschmid said Donaldson has described the budget as “lean” but “adequate.” Goldschmid said he agreed that the budget was lean, but said he’s “worried that the budgets in fiscal year 2007 and beyond–a pattern that occurred in the 1990s–could well lead to tragic regulatory and economic failures.” He warned those in attendance: “Keep your eyes on the adequacy of the resources available to the Commission.” When asked by Congressman Richard Baker (R-LA), chairman of the House Financial Services Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises in May, whether the SEC needed more staff, Eisenberg conceded that more staff should be considered, despite recent hirings of additional accountants.

Tittsworth says the SEC has more “gun power” in terms of money and the number of examiners than it did a few years ago. The SEC budget has basically doubled since the Sarbanes-Oxley Act was enacted in 2002. Total SEC funding rose from $450 million in 2002 to $900 million in 2005. SEC staff got a bump in pay post Sarbanes-Oxley as well. “That was part of the Sarbanes-Oxley deal; that SEC workers got pay parity,” Tittsworth notes. Bullard of Fund Democracy says some SEC staffers have gotten such a huge bump in pay–up to 50% more in some cases–that people are staying put. Besides Roye’s departure, “since I left [in 2000] there have been no departures from investment management, which is very unhealthy,” Bullard argues. The SEC has distributed the raises on a “pro-rata basis without any regard for performance,” so there are “people making 50% more than people in the same positions were [making] five years ago regardless of how well they’ve performed. That’s a substantive problem.” (For one attorney’s view of how the budget bump has affected regional enforcement actions, see You Can Fight the SEC, page 58.)

The Office of Compliance Inspections and Examinations has also increased by 50% the number of examiners dedicated to mutual funds and advisors, from 300 two years ago to more than 450 today. “That is a huge increase,” Tittsworth says. With 6,000 or so mutual funds and 7,000 to 8,000 registered investment advisors, will that be an adequate amount of examiners once hedge fund managers–which estimates put at several hundred at the least–start to register in February? “That’s a harder question,” he says.

At Donaldson’s request, the SEC recently implemented a new inspection regime called “risk targeted sweeps” in which the largest and riskiest firms are examined once every two years. That two-year cycle is augmented with what are called mini-sweeps, in which the SEC randomly selects firms to examine in between its two-year exams. ICI President Stevens told Congress that the SEC should curtail its use of sweeps, “in which staff tends to focus on a particular issue.” The sweeps “often involve voluminous and sometimes duplicative information requests from different regional offices,” he said. The exams “result in a piecemeal look at fund operations, usually without feedback to the funds,” he continued, and the exams “are inappropriately diverting finite fund resources that could better be spent on compliance efforts.” Bobroff, the fund industry consultant, says, “A week doesn’t go by that I don’t hear of another ‘sweep’ letter being issued involving money managers or mutual funds.” Stevens told Congress that he was glad to learn that the SEC is pursuing designating a “team of lead examiners for larger fund groups” that will develop a comprehensive knowledge base about the firm to ensure more efficient and well-targeted inspections.

The SEC’s previous exam cycle was every five years. The new cycle is Donaldson’s way of catching problems before they mushroom into full-blown scandals. “I don’t think anyone can tell you how the risk-based exam schedule is going to play out,” Tittsworth says.

Stevens of ICI also told Congress in his testimony that as part of the SEC’s “inward-looking reforms,” the securities regulator needs to immediately address a few shortcomings. He said there needs to be better coordination among different SEC divisions and offices that deal with mutual fund issues, as well as improvements in the speed with which the Division of Investment Management processes applications for exempting firms from complying with certain regulations. Eisenberg assured Congress that he will “examine the two-year lag in exemptions.”

There’s no question that the SEC faces some significant challenges this year. Finalizing contentious mutual fund reform rules, making its case in court, and finding a suitable replacement for Roye are but a few areas that will occupy the remainder of the SEC’s time in 2005. One lingering question will be whether Donaldson decides to give up the chairmanship this year. Since taking the helm in February 2003, Donaldson, out of necessity, has become one of the most activist-minded chairmen at the SEC.

Washington Bureau Chief Melanie Waddell can be reached at [email protected].


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