Article Law360

2 Pillars of Commonsense Reform

18 September 2017

Financial bubbles are inevitable — they have been documented since the Dutch tulip boom in the 1600s and undoubtedly occurred much further back. The impact of bubbles can be mitigated, or at least not exacerbated to the point of crisis, through thoughtful government involvement. The 2007-08 financial crisis, however, was deepened by the unintended consequences of government action, and recovery was stifled by a regulatory response that neither addressed the fundamental causes of the crisis nor helped protect against a future one. The Trump administration should undertake regulatory reform to alleviate the burdens imposed on U.S. markets over the last eight years.

American capital markets offer investors a broad range of products and vehicles in which to invest capital. While bank accounts essentially ensure you will receive a dollar back for each invested, other investments, such as stocks and shares of mutual funds, offer the potential for a higher rate of return in exchange for the risk that you may lose your investment. In 1980, the U.S. Securities and Exchange Commission obscured this basic concept by passing Rule 2A-7 under the Investment Company Act, allowing mutual funds to seek to maintain a stable $1 net asset value by using penny rounding and amortized cost accounting (meaning, the value of investments did not necessarily reflect the value in the market). Furthermore, to comply with Rule 2A-7, mutual funds had to follow strict investment limitations, leading to an appetite for short-term corporate debt that resulted in companies, including banks and investment houses, relying on money market funds for cash to run their businesses.

Consumers liked the sense of security offered by the $1 net asset value for money market funds, but what happens in a market downturn where the headlines are scary and people are losing their investments? On Sept. 12, 2008, Lehman Brothers, which had significant exposure in the collapsing subprime mortgage market, declared bankruptcy, and investors of the Reserve Primary Fund — a $62 billion money market mutual fund holding $785 million in commercial paper issued by Lehman Brothers — panicked and started redeeming their shares, causing the fund to sell its portfolio to pay redemptions. During the week of Sept. 15, U.S. investors withdrew about $300 billion (14 percent of assets) from prime money market mutual funds, sending ripples throughout the economy where companies had become dependent on short-term cash from these funds to run their businesses. On Sept. 19, 2008, the Treasury and Federal Reserve stepped in to essentially guarantee all the money market funds in the United States. It was an extraordinary step that eventually calmed investor panic.

During the financial crisis, the five largest investment banks regulated by the SEC — Bear Stearns, Merrill Lynch, Morgan Stanley, Lehman Brothers and Goldman Sachs — either went bankrupt, became banks or were acquired by a bank. Three months after the Lehman bankruptcy, the world discovered that Bernie Madoff was a fraud and the SEC had missed several chances to stop him and the Ponzi scheme he had been running for years. By the end of 2008, the SEC was being heavily criticized in the national media, by congressional overseers and by investors who had lost confidence in the agency’s ability to fulfill one of its core mandates — investor protection.

The perceived failures of the SEC empowered other federal agencies, like the Federal Reserve and Treasury, in battles over issues like how to reform money market funds. The Financial Stability Oversight Council, a powerful body of interagency regulators chartered by the Dodd-Frank Act to keep watch over the financial industry, decided to insert itself on this issue as an area of concern due to “systemic risk.” By involving the FSOC, where market regulators like the SEC are outnumbered by bank regulators such as the Federal Reserve and the Office of the Comptroller of the Currency, the SEC was underrepresented and outvoted by prudential regulators whose approach to safety and soundness operated on fundamentally different principles than the markets-based and disclosure-driven approach historically taken by the SEC.

The banking model is unsuited to the model of risk capital in the securities markets regulated by the SEC. Investors look to markets to put their capital at risk as equity or debt investors in publicly listed companies in order to earn a return on that capital. The United States has created the most vital markets in the world through a regime based on the full and fair disclosure of all material facts about publicly traded companies and accurate presentation of accounting information on such companies. This regime proceeds from the fundamental premise that investors, armed with all the material facts, can make the best decision about where to invest based on their risk tolerance. We should not assume that U.S. markets will remain pre-eminent. Misguided attempts to regulate these markets and their participants can damage them and harm U.S. growth.

As we consider how the government should prepare for future market disruptions and contemplate regulatory changes that would better prepare us to respond to such market events, consider these pillars of commonsense reform.

1. Regulatory bodies such as the FSOC should exist primarily for the purposes of sharing information and coordination between agencies. Agencies with expertise in particular areas of the market should be primarily responsible for crafting and implementing policy affecting their registrants.

The FSOC was created by a Democratic president and a Democratic majority in Congress during the immediate aftermath of the financial crisis. After its inception, the FSOC leveraged its emergency authority to grow and consolidate power. As recently as April 2016, the FSOC released a report challenging the independence of the asset management and broker-dealer industries. It raised purported red flags about asset managers having insufficient liquidity to pay investors if there is a massive run on a particular fund. It questioned complex uses of hedge fund leverage. The FSOC should concern itself with issues of real systemic risk concern and leave the regulation of the asset management industry and capital markets to expert agencies like the SEC.

The asset management industry already meets tough disclosure and reporting requirements. Hedge funds are going to use leverage. Mutual funds' holdings vary in how liquid they are, in order to provide investors with good returns. That's the nature of financial markets.

A body comprised of the senior federal financial regulators coming together on a periodic basis to share information about market trends and anticipate areas of weakness or disruption is prudent and necessary. After the 1987 market crash, the Presidential Task Force on Market Mechanisms (aka the Brady Commission) was created to student the stock market decline. The group was succeeded by the President’s Working Group on Financial Markets (aka the Plunge Protection Team), which also existed to ensure a measure of collaboration between key regulators. But those bodies still relied heavily on the member agencies' expertise and experience regulating particular segments of the market and did not use the group forum itself to expand their individual authorities.

The Trump administration’s blueprints for financial regulatory reform indicate a desire to preserve the existence of the FSOC. If that is indeed the case, the administration should seek to amend Dodd-Frank to take away the FSOC’s ability to designate financial firms as “systemically significant.” The Obama administration used such power to obtain settlements from designated firms and money from such settlements was directed to activist groups aligned with the Obama administration. The FSOC also used the threat of designation as a tool to promote its own regulation of the asset management industry. Taking away the designation power would prevent its misuse by future administrations.

2. Require regulators to closely examine the facts and data underlying proposed policies and analyze the potential consequences before instituting new regulation.

We must adopt a more fact-based approach to policy to reduce government interference in the economy. This means that when legislatures or agencies propose a new policy or law, they should be required to provide factual, objective evidence supporting the benefits of the proposal. The research must be conducted by well-qualified experts without vested interests in the result. Some call this "evidence-based policymaking," an extension of the practice of evidence-based medicine. Evidence-based policy is about making the process of lawmaking less ideological through the use of economically rigorous studies to identify programs and practices capable of improving outcomes.

Norm Champ is a partner in the investment funds group at Kirkland & Ellis LLP, where his clients include regulated asset managers and other financial institutions. He is a former director of the Division of Investment Management at the U.S. Securities and Exchange Commission, where he played a key role in the SEC’s completion of landmark reforms in 2014 to strengthen the $3 trillion money market fund industry, and led important structural and policy changes in the Division of Investment Management. He also led the SEC's interactions with the Financial Stability Oversight Council as the council turned its attention to whether asset management firms are “systemically important.”

This article was adapted from Champ’s book, “Going Public (My Adventures Inside the SEC and How to Prevent the Next Devastating Crisis).”

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

Norm Champ, P.C.

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