Stretched Too Thin?

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