Over the last two decades, many events have shaken the public’s trust in the financial markets—for example, the collapse of Enron, scandals at the New York Stock Exchange and within the mutual fund industry, the global recession, the implosion of the US mortgage finance market, and the scandals involving Bernard Madoff and Allen Stanford. These scandals have occurred just as retirement security is tied to properly functioning investment markets.
Perhaps even more damaging were the failures of public and private watchdog agencies to detect questionable practices and take decisive action to protect the investing public. Without rigorous safeguards and vigilant enforcement against conflicts of interest and collusion among the investors’ supposed agents—accountants, analysts, brokers, company directors, and executives—investors, particularly small investors, and the financial markets suffer. That retirees will depend on investments for their financial security makes it more important to prevent such calamities and breaches of trust.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) overhauled the regulation of the financial markets and the securities industry, making systemic changes in the securities markets. It reformed the regulation of nationally-recognized statistical rating organizations (NRSROs), which were criticized for failing to accurately rate the risk of mortgage-backed securities and other derivatives. The act also made several reforms to protect retail investors, which in turn may provide protections to the broader market.
While the act set out broad reforms, many details were left to regulators. The Securities and Exchange Commission (SEC) was charged with numerous rulemakings and studies. In addition the SEC shares responsibility with the Commodities Futures Trading Commission for reforming the derivatives market.
New investment products—federal law requires securities to be registered with the SEC unless they fall within an exemption from registration requirements. Generally, sellers of registered securities must disclose certain information about the securities they are offering. This may include information on industry risks, company risks, and investment risks. Retail investors have several investment options that are not regulated or lightly regulated; examples include private equity, private placements, and hedge funds. Private equity firms generally use private capital to invest in companies with the goal of selling the company or returning it to public ownership. Private placements are investments that are exempt from registration under federal securities laws. Small or startup companies rely heavily on private placements. These types of investments can yield great reward, but they also present great risk of loss.
Until recently, hedge funds, which are privately-offered managed pools of capital, operated largely outside the authority of securities regulators. Initially investment vehicles for extremely wealthy and sophisticated investors, they are increasingly attracting investments from pension and retirement funds that contain the savings of less affluent investors. Hedge funds promise the potential for high returns and a hedge against market downturns. They have become a force in the marketplace, with an estimated $2.9 trillion invested in more than 10,000 hedge funds globally. Dodd-Frank requires managers of large hedge funds, which it calls “private fund advisers” for this purpose, to register as investment advisers with the SEC. However, the act exempts several types of funds, including venture capital funds and smaller funds, and the law left the SEC much latitude on how to define these exemptions.
Only accredited investors may invest in many of these nonregistered securities. Both institutions and individuals may qualify to become accredited investors. Individuals may qualify in one of two ways, one based on wealth and the other based on income.
- The wealth threshold is a net worth (or joint net worth if married) of over $1 million, excluding the value of the primary residence at the time of purchase. Retirement savings are not excluded from the wealth calculation.
- The income threshold is $200,000 (or $300,000 for married couples) in each of the two previous years and a reasonable expectation of the same income level in the current year.
The financial crisis introduced a new list of derivatives and other exotic investment product names to the public, including credit default swaps, mortgage-backed securities, and collateralized debt obligations. These products were designed to spread or transfer investment risk. When the underlying investments of these products proved unsound, as was the case with mortgage-backed securities based on subprime mortgages, losses were spread across industries and affected institutional investors and the individuals who invested in them. Moreover, the resulting economic downturn affected even those with no investments at all. Many of these products were not well understood by investors or regulators and presented a high possibility of risk to the market.
Some products seemingly skirt regulatory oversight. Credit default swaps, for instance, share qualities of both insurance and securities. Credit default swap contracts insure investors against losses; there is also a trading market for the swaps themselves. There was little transparency in these transactions because they did not occur on any exchange. Neither securities regulators nor state insurance regulators had clear authority over them. A major accomplishment of Dodd-Frank is the implementation of a comprehensive framework to regulate the derivatives market and reduce the potential for it to disrupt the financial system. These financial instruments have been standardized and are now centrally cleared and traded with rules regarding establishing appropriate margins, increasing transparency, and reducing risk. Dealers and other major swap participants must keep records so that regulators and market participants are better able to understand and judge risks.
Public accounting and auditing standards—the Financial Accounting Standards Board (FASB) is a private nonprofit that establishes standards for accounting reports by nongovernmental entities. The SEC recognizes these standards. Some people allege that FASB standards, particularly the standard for “fair value measurements,” which includes the so-called “mark-to-market” accounting standard, played a role in bank failures during 2008. This standard requires that an asset’s value be pegged to its current market value.
The Public Company Accounting Oversight Board (PCAOB) is also a private nonprofit. It was created by the Sarbanes-Oxley Act to oversee auditors of companies listed on public stock exchanges. The PCAOB was granted authority to prohibit accounting firms from providing certain consulting services to public companies they are hired to audit. It enforces the requirement that chief executive officers and chief financial officers be personally responsible for the accuracy of their company’s financial reports. It is also charged with increasing the accountability of public company boards’ audit committees and establishing safeguards against conflicts of interest involving investment analysts.
Credit rating agencies—credit rating agencies have been criticized for failing to account for the riskiness of complex structured products during the lead-up to the financial crisis of 2008. As the crisis and subsequent recession unfolded, the assumptions underlying the methodologies to rate complex securities came under fire for being overly optimistic. Ratings downgrades later left the market for structured products almost nonexistent. Credit rating agencies, and NRSROs in particular, have been criticized for a lack of internal controls, for the conflicts of interest inherent in their issuer-pays business model, for a lack of transparency, and for a perceived absence of accountability.
Dodd-Frank addressed some of these issues by, for example, requiring greater transparency of rating procedures and methodologies. As with other provisions of the act, the details of reform were left to regulators. The act established the Office of Credit Ratings within the SEC to oversee NRSROs.
Stock options—a stock option is a right to purchase a specified number of stock shares at a later time and at a stated price, presumably a price that is lower than what the shares would otherwise be worth at the time of purchase. Stock options can be an important part of employee compensation, especially for highly paid employees.
Special-purpose entities—a special-purpose entity, or vehicle, is a legal entity a company sets up to fulfill an objective or perform a temporary task. It can protect the company by taking on the ownership of riskier assets. Some jurisdictions restrict or specify ownership interests in special-purpose entities. Problems can arise when companies use them to make it appear as if they are in better financial condition than they really are.
Say-on-pay—Dodd-Frank requires publicly traded companies to have independent compensation committees and give shareholders a nonbinding vote on executive compensation packages, a so-called say-on-pay. The provision, based on a model from the United Kingdom, is intended to encourage greater accountability and disclosure in setting executive compensation.
Conflict of interest for former SEC commissioners and employees—as with Congress and other federal agencies, federal ethics laws prohibit direct lobbying by former SEC commissioners and staff for at least one year after they leave the agency. The law is intended to limit conflicts of interest. SEC commissioners and staff develop specialized skills and knowledge about how markets work in addition to how they are regulated. Consequently, many former SEC commissioners and staff go on to work at law firms and other businesses that practice before the commission.
Maintaining Public Trust in Investment Markets: Policy
Strengthening watchdog agencies
Congress should appropriate adequate funding for the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) to perform all their duties under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Congress should permit conversion of the SEC and CFTC to self-funding, similar to that of federal banking agencies.
Appointments to the Public Company Accounting Oversight Board (PCAOB) should include individuals of high integrity with significant knowledge of the informational needs of individual investors and a strong commitment to the fair and effective implementation of both the Dodd-Frank Act and the Sarbanes-Oxley Act.
Similarly, individuals selected to fill vacancies on the SEC, the Office of Investor Advocate, and the Investor Advisory Committee should be of high integrity, have significant knowledge of the informational needs of individual investors, and be committed to effective investor protection.
In all such appointments, particular efforts should be made to minimize perceived conflicts of interest and enhance transparency.
Congress should preserve the protections of the Sarbanes-Oxley Act, including its disclosure and reporting requirements.
In issuing rules and regulations, the SEC, PCAOB, and Financial Accounting Standards Board (FASB) should strengthen transparency and disclosure with respect to public companies’ accounting standards and financial reporting.
The SEC should require analysts to disclose their ratings performance based on their stock choices and forecasted earnings.
SEC rules should ensure greater accountability of fund managers and disclosure of management fees and commissions.
FASB should require public companies that issue stock options to disclose this activity in their quarterly SEC filings. FASB also should strengthen guidelines governing the use and funding of special-purpose entities.
Conflict of interest
The PCAOB should carefully monitor the provision of nonaudit services by auditors and should use its authority under the Sarbanes-Oxley Act to prohibit such practices where they represent a conflict of interest.
Conflicts of interest in the current system of rating debt-backed securities should be minimized.
The SEC should adopt stronger conflict of interest rules to prohibit former commissioners and employees from lobbying the agency for at least two years.
Hedge funds and private equity funds
The SEC should interpret the requirements for registration of hedge fund managers and private equity fund managers to maximize transparency in the markets and increase the number of registrations.
The SEC should tighten the definition of “accredited investor” to protect retirement savings.
Derivatives and other exotic investment vehicles
Federal and state regulators should be given authority to regulate all derivatives and other similar exotic investment vehicles.
The SEC and the CFTC should work together and use the authority granted in Dodd-Frank to create a transparent market for derivatives and other exotic investments.
Initial public offerings
The SEC should review the process for initial public offerings to examine the feasibility of establishing a better system to promote fair pricing and open access.
Corporate boards and shareholder rights
Congress should tighten the definition of “independent director” under the Investment Company Act of 1940.
SEC regulations should ensure the independence of public company audit committees and strengthen the role of independent members of corporate boards of directors.
Shareholders should have an advisory vote on executive compensation practices. Financial firms should be required to have independent compensation committees and to disclose any compensation structures that include incentive-based elements.