Maintaining Public Trust in Investment Markets

Background

Safeguards and vigilant enforcement against conflicts of interest are needed to protect investors, particularly small investors, and the financial markets. And doing so is important to older adults because retirees depend on investments for their financial security.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) addressed some of the enforcement shortfalls in securities regulation. 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, which were criticized for failing to rate the risk of mortgage-backed securities and other derivatives accurately. The act also made several reforms to protect retail investors, which in turn may provide protections to the broader market.

Although 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.

Federal law requires most securities to be registered with the Securities and Exchange Commission (SEC). 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. Other types of investments available to retail investors 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 rewards, but they also present a great risk of loss.

Until recently, hedge funds, which are privately-offered managed pools of capital, operated largely outside the authority of securities regulators. Dodd-Frank requires managers of large hedge funds to register as investment advisers with the SEC. However, the act exempts several types of funds, including venture capital funds and smaller funds. In addition, the law left the SEC much latitude on how to define these exemptions.

Only accredited investors may invest in many of these unregistered 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 more than $1 million, excluding the value of the primary residence at the time of purchase. Retirement savings are included in 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 products to the public. These include 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, losses spread across industries and affected institutional investors and the individuals who invested in them.

Dodd-Frank implemented a comprehensive framework to regulate the derivatives market and reduce the potential for it to disrupt the financial system. In the wake of Dodd-Frank, these financial instruments are increasingly standardized and centrally cleared. These financial instruments are standardized and centrally cleared. They are traded with rules that govern the following:

  • 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.

Say-on-pay—Dodd-Frank requires publicly traded companies to have independent compensation committees and give shareholders a non-binding vote on executive compensation packages, a so-called say-on-pay. The provision 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 (see also Chapter 1, Government Integrity and Civic Engagement: Ethics and Accountability).

MAINTAINING PUBLIC TRUST IN INVESTMENT MARKETS: Policy

Strengthening watchdog agencies

In this policy: Federal

Investment watchdog agencies should be adequately funded. Their employees should be knowledgeable and mission-driven, and act with integrity. They should not have conflicts of interest.

Congress should appropriate adequate funding for the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC) to perform all their duties to protect retail investors and promote the integrity of our financial markets. Congress should permit conversion of the SEC and CFTC to self-funding, which would increase the independence of the 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.

Disclosures

In this policy: Federal

Rules and regulations should favor effective transparency and disclosure requirements. Policymakers should improve the timing and readability of disclosures to retail investors, including disclosures about investment professionals and investment products. The SEC should test all disclosures with consumers prior to implementation to ensure that they provide meaningful and understandable information.

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 to investors 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.

Minimizing conflicts of interest

In this policy: Federal

Regulators should eliminate or minimize conflicts of interest, particularly with respect to rating debt-backed securities.

The SEC should adopt stronger revolving door rules to prohibit former commissioners and employees from lobbying the agency for at least two years (see also Chapter 1 – Government Integrity and Civic Engagement: Lobby Reform).

Promoting transparency, accountability, and independence

In this policy: FederalState

Regulators should increase transparency, accountability, and independence. Regulations should promote consumer protections.

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.

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.

The SEC should review the process for initial public offerings to promote fair pricing and open access.

The SEC should tighten the definition of “independent director” under the Investment Company Act of 1940. This will increase shareholder rights.

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.