SEC OFFICIAL EXAMINES DODD-FRANK LEGACY AS REGULATORY CHANGES LOOM

SEC SealIn a recent speech, SEC Investor Advocate Rick A. Fleming discussed the future of financial regulation in general and the impact and legacy of the Dodd-Frank Act. He concluded that sound financial regulation focused on “the protection of investors must serve as the first principle guiding our financial regulations … we should think of those regulations not as a burden to be repealed or picked apart haphazardly, but as the essential nutrient for flourishing capital markets.”

He addressed three particular aspects of the financial crisis and the role played by the SEC and the Dodd-Frank response to each situation. In discussing asset-backed securities, he noted that many investors were not fully aware of the risks underlying the securitized assets until it was too late, when they suffered heavy losses. According to Fleming, the SEC disclosure rules adopted under Section 942 of the Dodd-Frank Act enable investors to conduct their own due diligence in order to better assess the credit risk of asset-backed securities. Potential investors are now able to see a more complete picture of the composition, characteristics and performance of the assets in a securitized pool rather than merely “blindly relying on credit ratings.”

Fleming also pointed out the beneficial impact of the risk retention rules, which require ABS sponsors to maintain a financial interest, or “skin in the game,” in an ABS transaction, “Theoretically, at least” he said, “risk retention will discourage the creation and sale of toxic securities in the future.”

He cited the Financial Crisis Inquiry Commission’s (FCIC) conclusion that the Commodity Futures Modernization Act of 2000 was “a key turning point in the march toward the financial crisis” due to its restrictions on state and federal regulation of the over-the-counter derivatives market. Fleming stated that the resulting opacity in the OTC derivatives market was problematic. He agreed with the FCIC that “the existence of millions of derivatives contracts of all types between systemically important financial institutions—unseen and unknown in this unregulated market—added to uncertainty and escalated panic.”

The SEC effectively responded to the crisis, according to Fleming, by establishing a comprehensive regulatory framework for “the entire ecosystem of security-based swaps.” Existing rules provide for the registration with the SEC of swap dealers, major security-based swap participants and security-based swap data repositories. The Commission also adopted rules governing clearing agencies.

Despite those accomplishments, however, Fleming stated that the SEC had work left to do in the OTC derivatives space. He noted that the Commission has yet to act on rules that would govern security-based swap execution facilities and set capital and margin requirements for security-based swap dealers and major security-based swap participants that are not banks. Due to the work of the SEC in the OTC derivatives market, according to Fleming, “in place of opacity, we will now have visibility ... in place of a tangled skein of blind spots that led to financial panic, we now have an established framework of transparency and regulatory oversight over an $11 trillion market.”

In discussing the role of credit rating agencies, Fleming noted that SEC regulation may not have gone far enough. The rules that address the governance, accountability and management of credit rating agencies, and remove almost references to credit ratings from SEC regulations and forms are positive developments, but in his view, the Commission’s rulemaking has a major shortcoming. While the rules require credit rating agencies to manage the conflicts of interest that are inherent in their business model, and mandate that agency CEOs certify as to the effectiveness of the firm’s internal controls and that ratings were not influenced by other business activities, the SEC stopped short of adopting an outright ban on the conflict-of-interest model in which issuers pay for their own credit ratings.

Fleming asked whether the conflicts inevitably presented by this business model can be effectively managed and mitigated. He concluded that the Commission should “maintain its vigilance in overseeing the industry and in monitoring the impact of the reforms.”

Overall, Fleming concluded that the SEC rulemaking under the Dodd-Frank Act successfully addressed many of the causes of the financial crisis.  The rulemakings are imperfect in his view, but they were a “drastic improvement” over the pre-crisis status quo. “In my view, then, we should not roll back these important reforms,” he concluded.

While it is impossible to predict the future of financial regulation, the change in administrations is certain to see more attempts in Congress to roll back provisions of the Dodd-Frank Act. That statute created Fleming’s position, the SEC Investor Advocate. As Fleming noted, that provision indicated a recognition that the voices of investors were underrepresented at the SEC in the years leading up to the financial crisis. In the Financial CHOICE Act, introduced by House Financial Services Committee Chairman Jeb Hensarling, however, Congress takes a shot at the investor advocate position. The bill, which may indicate the approach that the new Congress will take to financial regulation, restricts the authority of the investor advocate. Section 410 of the Financial Choice Act prohibits the investor advocate from taking a position on any legislation before Congress except for bill recommended by the advocate.