REMARKS BY FDIC VICE CHAIRMAN HOENIG ON 5 YEAR ANNIVERSARY OF LEHMAN BROTHERS MELTDOWN

FROM:  FEDERAL DEPOSIT INSURANCE CORPORATION 
Lehman Brothers: Looking Five Years Back and Ten Years Ahead
Remarks by Thomas M. Hoenig, Vice Chairman, Federal Deposit Insurance Corporation
Presented to the National Association of Corporate Directors, Texas TriCities Chapter Conference, Houston, Texas 
September 2013 
Introduction

A fundamental principle in economics is that incentives matter.  If the rules of the game provide advantages to some over others, protect players against the fallout of taking on excessive risk, or enable irresponsible behavior, we can be confident that the choices people make will be imprudent and the results of the misaligned incentives will be bad.

In the US financial system these conditions were in force during the decade leading to the Great Recession. It was a decade when monetary policy was highly accommodative; when government protections and subsidies were extended to ever more financial activities; when market discipline became a buzz word rather than a tool; and when the competitive advantage bestowed on some sectors of the industry led to a less competitive market.

More concerning is that five years after the crisis, despite new laws and regulations, we are replicating many of the conditions that contributed to the crisis, but we somehow are expecting things to end differently.   How so?

This morning, I will discuss the parallels between this earlier period and now, and I will make a case for a bolder set of actions to address weaknesses in a system that continues to impede our financial markets and economy.

Setting the Stage: Low Interest Rates

Extended periods of exceptionally low interest rates undermine a sound economy.  Their short-term effects on the economy can be favorable and dramatic, which creates a significant temptation for policymakers to keep rates low for a considerable period.   However, history suggests that extended periods of abnormally low rates often lead to negative long-run effects as they weaken credit standards, encourage the heavy use of credit, and too often adversely affect financial and economic stability.

For example, starting with the Mexican financial crisis of 1994 through the Asian and Russian crises of the late ’90s, aggressive expansionary US monetary policy was used with apparent success.  In each instance, the immediate crisis was staunched, markets continued operating, and the economy bounced back. Such success led to the expectation that monetary policy could clean up the effects of any financial excess or imbalance that the US economy might develop.   Low interest rates became the expected remedy that would stimulate the economy and avoid recession, or that would prevent the proliferation of a crisis.

Having been successful during the ’90s, the Federal Open Market Committee (FOMC), "doubled down" its use of low interest rates during the subsequent decade as it encountered financial and economic weaknesses. Following the collapse of the tech bubble, the real federal funds rate was negative for most of the period 2002 through 2005. It is noteworthy that in June 2003, the nominal federal funds rate was lowered from 1 1/4 percent to 1 percent and remained there for nearly a year, despite the fact that the economy grew at a rate of nearly 7 percent in the quarter following this rate reduction.

Because there were no signs of accelerating inflation, the FOMC felt confident that there was no need to quickly reverse policy, so it remained either highly or relatively accommodative well into the recovery. The first increase in the federal funds rate occurred in June 2004, only after evidence was overwhelming that economic activity had begun to accelerate. Not until March 2006 did the federal funds rate reach its long-term average level.

Within an environment of a highly accommodative monetary policy and sustained low interest rates, credit growth accelerated and serious financial imbalances developed. During the period 2002 to the end of 2007, total debt outstanding for households and financial and non-financial firms increased from $22 trillion to $37 trillion, or almost 70 percent. In hindsight, of course, it seems obvious that problems would result.

This history begs the question, therefore, of how current monetary policy might affect economic and financial conditions in 2013 and beyond. The FOMC again is fully engaged in conducting a highly accommodative monetary policy. The target federal funds rate is currently zero to 25 basis points. Through the Federal Reserve’s Quantitative Easing policy, its balance sheet and bank reserves have ballooned to nearly four times the size they were in January 2008. As a result, the real federal funds rate has been negative for most of the period from 2008 to the present.

As with the earlier period, inflation in the US remains relatively subdued, facilitating continued low rates. However, the US also is experiencing significant price increases in various assets, including, for example, land, stocks, and bonds. Banks and the entire financial sector are exposed, directly and indirectly, to significant negative price shocks in nearly all interest rate-sensitive sectors. Also, as capital desperately seeks out yield, there have been significant US dollar capital flows across the globe, causing what appears to be increased financial vulnerability, uncertainty, and instability.

Thus, the actions the FOMC has taken since the crisis ended are more aggressive and will be in place far longer than those taken in the early part of the last decade.

Those who support current money policy insist that circumstances are different this time - a phrase itself that should cause alarm. They suggest that policymakers have better tools to deal with imbalances in the form of renewed market discipline and macro-prudential supervision. However, as I describe below, financial conditions within the system are not as different than many presume. Market discipline has not been strengthened, and macro-prudential supervision may be a new name but it is hardly a tool that was unavailable in the earlier period.

Extending the Safety Net: Adding Risk to the System

During the early part of the last decade, at the time the US was engaging in a systematic expansion of monetary policy, it had just extended the public safety net to an ever wider set of financial activities and firms. In 1999, the Glass-Steagall Act was repealed, which confined the safety net – defined as access to the Federal Reserve liquidity facility and FDIC insurance -- to commercial banks. In its place, the Gramm-Leach-Bliley Act was passed to allow the melding of commercial banking, investment banking, and broker-dealer activities. These changes were intended to enhance the market's role in the economy, to increase competition, and to create a more diversified, stable system.

In practice, however, Gramm-Leach-Bliley undermined that very goal. It allowed firms with access to the public safety net to control a much wider array of financial products and activities, and it provided them a sizable advantage over financial firms outside the safety net. It enabled firms inside the net to fund themselves at lower costs and expand their use of debt -- that is, to lever-up. Under such conditions, firms outside the net, to survive, found it necessary to join this favored group through mergers or other actions. The result is a more highly concentrated industry that is more dependent on government support and where, in the end, the failure of any one firm threatens the broader economy.

Gramm-Leach-Bliley fundamentally changed the financial industry’s business model. Previously, commercial banking involved principally the payments system that transfers money around the country and world, and the intermediation process that transforms short-term deposits into longer-term loans. That model cultivated a culture of win-win, where the success of the borrower meant success to the lender in terms of the repayment of the loan and growth of the credit relationship.

After Gramm-Leach-Bliley, as broker dealer and trading activities began to dominate the banking model, the culture became one of win-lose, with the parties placing bets on asset price movements or directional changes in activity. Thus, broadening the range of activities and risks that banking firms could bring within the safety net changed the risk/return trade-off and significantly changed the incentive structure in banking. While such non-traditional commercial banking activities are essential to the market's function, placing them within the safety net became lethal to the industry and to the economy.

A related effect of the government’s rich financial subsidy was a significant increase in industry leverage, especially among the largest firms. Between 2000 and 2008, the leverage among the 10 largest US firms reached unprecedented levels, as the ratio of tangible assets to tangible common equity capital increased from 22 to 1 to levels exceeding 47 to 1.1

Once the financial panic was set in motion and confidence was lost, firms were forced to rapidly deleverage their balance sheets, creating a chaotic market. The effects were channeled through a highly interconnected financial system to the real economy, causing significant declines in asset values, wealth, and jobs. Between 2008 and the end of 2009, well over 8 million jobs were lost within the US economy alone, and containing the crisis required enormous amounts of FDIC and taxpayer support.

Now, five years after the crisis, we should not ignore that many of the conditions that undermined the economy then still remain within our financial system. These conditions include: a few dominant financial firms – those that are too big to fail - controlling an ever greater portion of financial assets within the US; continued government protections and related subsidies; and the continued reliance on a business model with its heavy use of debt over equity and increased risk in the pursuit of higher, subsidized returns on equity.

Yes, the Dodd-Frank Act introduced hundreds of regulations designed to control the actions of financial firms. It gives financial supervisors increased oversight of firms and activities, and it requires the Federal Reserve and the FDIC to oversee the development of resolution programs for the largest firms. However, when you work through the details, the law and rules mostly reiterate powers long available to supervisors. It adds numerous rules and moves responsibilities among regulators, but it makes no fundamental change in the industry’s structure or incentives that drive firms’ actions.

Dodd-Frank adds new supervisory and resolution authorities intended to end bail outs of financial firms and related subsidies. However, this is an old promise and has yet to be successfully implemented. Consider that the US financial system is more concentrated today and the largest firms hold more market power than prior to the crisis. The 10 largest financial firms control nearly 70 percent of the industry's assets, up from 54 percent in 2000. The eight globally systemic US banking firms hold in assets the equivalent of 90 percent of GDP, when you place the fair value of derivatives onto their balance sheets. Moreover, given the breadth and complexity of activities of these firms, they remain highly interconnected and the failure of any one will likely cause a systemic crisis, demanding government intervention.

Dodd-Frank introduces new rules designed to check the expansion of the subsidy. The Volcker Rule, for example, is supposed to move bank trading activities away from the insured bank. However, the rule has yet to be implemented, and even if it is fully implemented, it allows broker-dealer activities to stay within the same corporate entity, which itself benefits from the government’s safety net.

Consistent with these observations, there is a long list of studies documenting the existence of a government subsidy unique to the largest firms that extends across their balance sheets. While the industry vigorously argues that no subsidy exists, the preponderance of evidence suggests otherwise.2 Thus, while new authorities designed to mitigate this subsidy have been introduced, they have yet to be used or successfully tested. It is worth noting, for example, that under the Bank Holding Company Act, regulatory authorities have long had the authority to force divestiture of non-bank affiliates if they threaten the viability of the related bank. To my knowledge, this authority has never been used.

Therefore, as before the crisis, too big to fail and its subsidy continue to affect firms’ behavior. They enable the largest firms to fund themselves at lower cost than other firms providing a competitive advantage that facilitates the biggest firms’ dominance within the industry and multiplying their impact to the broader economy.

Also, although the US has introduced a supplemental leverage ratio to the capital standards, these largest firms carry significantly more leverage following from the subsidy than the industry more broadly. Using International Financial Reporting Standards, the average leverage ratio of the eight globally systemic US banks is nearly 25 to 1.3 This leverage is comparable to what the largest US firms carried in the years leading up to the crisis in 2008 and, as events demonstrated, it reflects too little capital to absorb significant shocks that might occur within the financial sector.

These leverage ratios stand in contrast to those for the remainder of the US banking industry. For example, the average leverage ratio for each category of banks -- from community, to regional, to super-regional -- is less than 14 to 1. This lower ratio reflects the fact that creditors of these firms are more directly exposed to loss should failure occur and, therefore, they insist on a larger capital cushion.

Thus, in comparing today’s financial system to that of 2008, I worry that the industry is more concentrated, that the system remains vulnerable to shock, and that the economy remains vulnerable to crisis. Even within the confines of Dodd-Frank, the industry’s structure, incentives and balance-sheets are more similar to 2008 than different. And, as always, we can’t anticipate the source of the shock until it strikes.

Rethinking Status Quo Solutions

It has been noted that, “We cannot solve our problems with the same thinking we used when we created them.”4 The economy has struggled through this recovery in a post Dodd-Frank environment perhaps because the public realizes that while we have more rules, too little has changed. It is my hope that people remain cautious so that five years from now – ten years after the collapse of Lehman Brothers – we will not be in an all-too-familiar place, facing an all-too-familiar banking crisis.

We need to regain our economic footing by rethinking our solutions. As I have been suggesting since before joining the FDIC, the US requires a monetary policy that better balances short-term and long-term policy goals. We need to rationalize, not consolidate, the structure of the financial industry and narrow the federal safety net to its intended purpose of protecting only the payments and intermediation systems that commercial banks operate.5 At a minimum, simplifying the structure would enhance the FDIC’s ability to implement its new authorities to resolve institutions should they fail. In addition, the US must lead the world in strengthening and simplifying the capital requirements for regulated financial firms, particularly for the largest, most systemically important firms.6 A strong capital base for individual firms and the industry is essential to a strong, market-based financial system.

A decentralized financial structure supported by a strong capital base and market accountability, too long ignored but fundamentally correct, would further change industry incentives and strengthen its performance. Finally, and importantly, these conditions would make the industry more responsive to the market, providing opportunity for success and failure -- both of which are essential elements of capitalism.



The views expressed are those of the author and not necessarily those of the FDIC

1 Tangible common equity capital is total equity capital less non-Treasury preferred stock, goodwill and other intangible assets.

2 http://www.fdic.gov/news/news/speeches/litreview.pdf
http://www.richmondfed.org/publications/research/special_reports/safety_net/pdf/safety_net_methodology_sources.pdf

3 The International Financial Reporting Standards (IFRS) approach to financial statement reporting is set by the International Accounting Standards Board.  A significant difference between U.S. GAAP and IFRS is IFRS only allows the netting of derivative instruments on the balance sheet when the ability and intent to settle on a net basis is unconditional. http://www.fdic.gov/about/learn/board/hoenig/capitalizationratios2q13.pdf

4 The quote is widely attributed Albert Einstein, though scholars have not verified its authenticity. http://www.albert-einstein-quotes.org.za/

5 “Restructuring the Banking System to Improve Safety and Soundness” white paper by Thomas M. Hoenig and Charles S. Morris - http://fdic.gov/about/learn/board/Restructuring-the-Banking-System-05-24-11.pdf
“A Turning Point: Defining the Financial Structure” speech by Thomas M. Hoenig to the Annual Hyman P. Minsky Conference at the Levy Economics Institute of Bard College. April 17, 2013 - http://fdic.gov/news/news/speeches/spapr1713.html

6 “Basel III Capital: A Well-Intended Illusion” speech by Thomas M. Hoenig to the International Association of Deposit Insurers 2013 Research Conference in Basel, Switzerland. April 9, 2013 - http://fdic.gov/news/news/speeches/spapr0913.html

SEC CHAIR WHITE ISSUED STATEMENT AFTER MEETING WITH LEADERS OF EXCHANGES

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 

Securities and Exchange Commission Chair Mary Jo White today issued the following statement after meeting with leaders of the equities and options exchanges, FINRA, DTCC, and the Options Clearing Corporation.

Chair White called the meeting immediately following the August 22 interruption in the trading of NASDAQ-listed securities.

“Our securities markets are strong and work effectively for millions of investors and businesses.  The orderly functioning of those markets and the robustness of our market infrastructure are vitally important to our nation’s economy.  That is why we hold ourselves to very high standards.

“Today’s meeting was very constructive.  I stressed the need for all market participants to work collaboratively – together and with the Commission – to strengthen critical market infrastructure and improve its resilience when technology falls short.  To that end, I asked those at the meeting to work constructively with the Commission staff as we continue to consider ways to enhance the integrity of market systems.  They pledged to do so and I expect other market participants will do so as well.

“In short order, I also want those at the meeting – with the input of other market participants – to identify a series of concrete measures designed to address specific areas where the robustness and resilience of market systems can be improved, including the systems that were at the core of last month’s trading interruption.  The investing public deserves no less.”

SEC FILES INJUNCTIVE ACTION AGAINST ALLEGED FRAUDULENT PROMISSORY NOTE OPERATOR

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION 
SEC Files Civil Injunctive Action Against Alleged Perpetrator and Unregistered Broker in Fraudulent Promissory Note Offering

On September 9, 2013, the Securities and Exchange Commission filed a civil injunctive action in the United States District Court for the District of Colorado against Brian G. Elrod for allegedly conducting a fraudulent offering of promissory notes for which Nova Dean Pack acted as an unregistered broker. Elrod and Pack reside in Buffalo Creek, Colorado and Highland, California, respectively.

The Complaint alleges that, from at least March 2009 through November 2009, Elrod and Pack raised approximately $2 million from 12 investors who invested in high-yield promissory notes issued by CFS Holding Company LLC (“CFS”), a Colorado company owned and managed by Elrod. According to the Complaint, Elrod told investors that their investments were secured and guaranteed and would generate annual returns ranging from 12% to 24%. According to the Complaint, Elrod further represented to investors that the proceeds from their promissory notes would be used to expand a group of financial services companies owned and managed by Elrod. The Complaint alleges that the foregoing representations, among others, were false and misleading when made, and that Elrod, rather than use investor money for legitimate business purposes, improperly used most of the investor funds to make substantial payments to himself and family members and to pay for personal expenses, to pay Pack significant commissions for referring investors, and to make interest payments back to investors. According to the Complaint, the CFS note offering was not registered with the Commission, and Pack was not an associated person of a registered broker or dealer at the time he participated in the CFS note offering.

Without admitting or denying the SEC’s allegations, Elrod and Pack agreed to settle the case against them. The settlement is pending final approval by the court. Specifically, Elrod consented to the entry of a final judgment permanently enjoining him from future violations of Sections 5 and 17(a) of the Securities Act of 1933 (“Securities Act”) and Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 thereunder, and requiring him to pay disgorgement of $1,720,491, the amount of his ill-gotten gains, plus prejudgment interest of $295,817, and a civil penalty of $1,720,491. Pack consented to the entry of a final judgment permanently enjoining him from future violations of Section 5 of the Securities Act and Section 15(a) of the Exchange Act, and ordering disgorgement of $171,500 plus prejudgment interest of $25,177, but waiving payment and not imposing a civil penalty based upon his financial condition.

SPEECH BY NORM CAMP ON "SEC PRIORITIES REGARDING HEDGE FUND MANAGERS"

FROM:  U.S. SECURITIES AND EXCHANGE COMMISSION

Current SEC Priorities Regarding Hedge Fund Managers

 Norm Champ

Director of the Division of Investment Management

PLI Hedge Fund Management Conference, New York, New York

Sept. 12, 2013

Thank you, Nora, for the kind introduction.  Good morning and thank you for inviting me to speak to you today – it is a privilege to open-up this seminar on behalf of such a distinguished panel of seasoned practitioners, some of which are current or former colleagues. I am certain that you will benefit from their invaluable insight into some of the trends and challenges facing the hedge fund industry.  Before proceeding, let me remind you that the views I express are my own and do not necessarily reflect the views of the Commission, any of the Commissioners, or any of my colleagues on the staff of the Commission.[1]

This is truly an opportune time to examine the regulatory landscape for hedge funds and their advisers – many of you are probably returning from vacations during a summer that witnessed the third anniversary of the enactment of the Dodd-Frank Act and just in time for the effective date of some significant rulemakings relating to a private placement exemption often used by hedge funds.  As you know, the Dodd-Frank Act imposed greater oversight on advisers to hedge funds, while recent changes were made to the private placement exemptions by the JOBS Act.  These changes create both opportunities and challenges for those advisers managing hedge funds.

For this morning, I will begin with a discussion on what you are likely most interested in – the general solicitation and the “bad actor” rules.  Afterward, I will focus on our continuing efforts to be better informed regulators. In the post-Dodd-Frank era, we are more cognizant regulators not only because of the enhanced data we receive from you regarding the size and operations of your industry, but also due to our continuous efforts to improve our ability to use that data and our heightened focus on industry awareness.  After an overview of what we now know about your industry and how we intend to use it, I’ll highlight some regulatory initiatives of interest to the hedge fund industry.  However, before I finish this morning, I want to briefly share some thoughts on the importance of a robust culture of compliance, which is underscored by the recent Commission actions against hedge fund managers for insider trading.

General Solicitation and Bad Actors

Over the summer, the Commission adopted two significant Congressionally-mandated changes to Rule 506 of Regulation D—the private placement exemption that many hedge funds rely on to offer their interests in the U.S.  Before addressing some specific aspects of these rules, it may be helpful to quickly revisit how we got here.  As most of you know, the JOBS Act mandated that the Commission lift the ban on general solicitation and general advertising to, among other things, provide new ways for companies to raise capital.  We are committed to taking steps to pursue additional investor safeguards if and where such measures become necessary once the ban on general solicitation is lifted.[2]  In other words, as we fulfill our mission to facilitate capital formation, we remain focused on strong investor protections.  Therefore, in connection with the changes to Rule 506, the Commission proposed additional amendments intended to enhance the Commission’s ability to evaluate the development of market practices in Rule 506 offerings and address certain concerns raised by commenters related to the types of investors that would be attracted by general solicitation.[3]

Lifting the Ban on General Solicitation

The first change to Rule 506 eliminates the prohibition on general solicitation and general advertising for certain offerings, including hedge fund offerings, provided that the conditions of the new rule are met.[4]  Once the removal of the ban goes effective in the next few weeks, hedge fund issuers will be able to use a number of previously unavailable solicitation and advertising methods when seeking potential investors.  However, with these new marketing opportunities also comes greater responsibility.

The final rule permits issuers to use general solicitation and general advertising to offer their securities if, among other things, issuers take reasonable steps to verify “accredited investor” status, and all purchasers of the securities are accredited investors – meaning that, at the time of the sale of the securities, they fall within one of the categories of persons who are accredited investors, or the issuer reasonably believes that they do.  Determination of the reasonableness of the steps taken to verify that an investor is accredited is by an objective assessment by an issuer, and in response to comments, the final rule provides a non-exclusive list of methods that issuers may use to satisfy the verification requirement for individual investors.

With general solicitation and general advertising soon to be an option, I want to reiterate the Commission’s reminder from the adopting release that advisers to private funds are subject to an anti-fraud rule that prohibits fraudulent and misleading conduct with respect to fund investors, including making untrue statements of material fact to those investors.[5]  In the adopting release, the Commission also noted that investment advisers that have implemented appropriate policies and procedures regarding the nature and content of private fund sales literature are less likely to use materially misleading advertising materials, or otherwise violate federal securities law.[6]  Accordingly, advisers should carefully review their policies and procedures to determine whether they are reasonably designed to prevent the use of fraudulent or misleading advertisements and update those policies where necessary, particularly if the hedge funds intend to engage in general solicitation activity.  Hedge fund sponsors intending to rely on the new rule should also consider whether their current practices for verifying accredited investor status meet the requirements of the new rule. 

Simultaneously with the adoption of these amendments, the Commission also issued a proposal designed to enable the Commission to evaluate how general solicitation impacts investors in the private placement market. The proposed measures include, among other things, expanding the information that issuers must include on Form D, requiring issuers to file the Form D before a general solicitation begins and when an offering is completed, and putting in place a more effective mechanism for enforcing compliance with Form D filing requirements. 

Given that private funds raise a significant amount of capital in Rule 506 offerings, the proposal contains several amendments specific to private funds.  For example, private fund issuers would be required to include a legend in any written general solicitation materials disclosing that the securities being offered are not subject to the protections of the Investment Company Act of 1940.  With respect to written general solicitation materials containing performance data, additional disclosure would be required to explain the limitations on the usefulness of such data and provide context to understand the data presented.  

The Commission also proposed to extend guidance contained in Rule 156 under the Securities Act of 1933, currently applicable to registered funds, on when information in sales literature could be fraudulent or misleading for purposes of the federal securities laws.  This guidance would apply to all private funds whether or not they are engaged in general solicitation activities. In the proposing release, the Commission expressed its view that private funds should now begin considering the principles underlying existing guidance. 

Furthermore, the Commission requested comment on additional manner and content restrictions on private fund solicitation materials.  In particular, we are interested in hearing your thoughts on content restrictions on performance advertising generally, and content standards specific to certain types of performance advertising, such as model or hypothetical performance. We also are interested in your views on whether private funds should be subject to standardized performance reporting and if so, what reporting standards should apply.

In order to assist the Commission’s efforts to assess developments in the Rule 506(c) market, an inter-Divisional group has been created within the Commission to review the new market and the practices that develop.  Staff from the Division of Investment Management will play a key role in this initiative, and will work closely with staff from the Division of Corporation Finance, the Division of Economic and Risk Analysis (“DERA”), formerly the Division of Risk, Strategy and Financial Innovation, the Division of Trading and Markets, the Office of Compliance Inspections and Examinations, (“OCIE”), and the Division of Enforcement.  As part of the work plan, staff will, among other things, evaluate the range of accredited investor verification practices used by issuers and other participants in these offerings, and endeavor to identify trends in this market, including in regard to potentially fraudulent behavior.  Commission staff will also develop risk characteristics regarding the types of issuers and market participants that conduct or participate in offerings involving general solicitation and general advertising and the types of investors targeted in these offerings. 

In addition, I’ve instructed Division of Investment Management rulemaking and risk and examination staff to pay particular attention to the use of performance claims in the marketing of private fund interests.  In particular, this review will endeavor to identify potentially fraudulent behavior and to assess compliance with the federal securities laws, including appropriate Investment Advisers Act provisions.  I encourage you to provide us information about what you are seeing develop in regards to general solicitation by private funds, particularly advertisements that appear to raise concerns.

Separately, the Commission has also begun a review of the definition of accredited investor as it relates to natural persons.  The Commission also requested comment on the definition of accredited investor in its recent proposing release.  Your input into all these regulatory initiatives is important.  With the comment period for the proposals regarding the Rule 506(c) market about to close, we strongly encourage you to submit comments if you have not done so already.

The “Bad Actor” Amendment

Under the second adopted amendment, commonly referred to as the “bad actor” amendment, an issuer cannot rely on the Rule 506 exemption from registration if the issuer or any other person covered by the rule is disqualified by a “triggering event,” which includes certain criminal convictions, certain SEC cease-and-desist orders and court injunctions and restraining orders.[7]  In addition to issuers such as hedge funds, other potential “bad actors” under the rule could include a hedge fund’s general partner or managing member, its investment adviser and principals, significant shareholders holding voting interests, affiliated issuers and any placement agent or other compensated solicitor.

The final rule provides an exception from disqualification for issuers that can show they did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering.  Given the serious consequences of a bad actor finding, hedge  fund advisers should take care when hiring employees and screening investors, and conduct appropriate due diligence when retaining third party solicitors.  Also, it is important to note that while disqualification applies only for triggering events that occur after the effective date of the rule, matters that existed before the effective date of the rule that would otherwise be disqualifying are required to be disclosed to investors.

I understand that the staff has received some interpretative questions with respect to the application of these rules, especially to private funds and their advisers.  Right now, the staff is in listening and information collection-mode, and is evaluating the need for guidance.

What We Now Know About the Industry

As I alluded to earlier, as a result of registration and reporting reforms introduced by, or tangential to, Dodd-Frank, we now have a more complete picture of the hedge fund universe, including insight into (for starters) the number of advisers and funds, the different types of funds, the strategies that they employ, and the makeup of their investor base. Now, it is critical to the execution of our mission that we are able to translate being better informed regulators into being more effective regulators.

Today, the Commission’s registrant population consists of over 10,825 advisers, with 2,572 of these advising at least one hedge fund.[8]  Overall, advisers of hedge funds account for over $4.6 trillion in cumulative regulatory assets.  In addition to hedge fund advisers registered with the Commission, we also have exempt reporting advisers, or ERAs, who are those advisers that are exempt from registering with the Commission, but are subject to limited reporting about their businesses and their private fund clients.  The Commission has approximately 2,400 ERAs, with 767 advisers or 32% of these managing hedge funds accounting for over $819 billion in regulatory assets. 

This improved information is the result of upgrades to Form ADV and the arrival of Form PF.  In 2011, the Commission adopted amendments to Form ADV requiring significant additional information with respect to, among other things, the identity of hedge fund clients, amount of gross assets, names of service providers to these hedge funds, and the number and types of hedge fund investors.[9]  Also in 2011 the Commission adopted new Form PF jointly with the Commodity Futures Trading Commission.  Form PF requires advisers to report the use of leverage, counterparty credit risk exposure, and trading practices for each hedge and other private fund managed by the adviser.[10]  In the summer of 2012, the Commission began to receive the first set of Form PF filings from the largest advisers of hedge funds and other private funds, and received a complete set of initial filings from all reporting advisers earlier this year. 

How We Can Use the New Information

While the primary aim of Form PF was to create a source of data for the Financial Stability Oversight Council (“FSOC”) to use in assessing systemic risk,[11] the Commission, consistent with statutory authority, is using the information to support its own regulatory programs, including examinations, investigations and investor protection efforts relating to private fund advisers.  Through a coordinated effort of staff across the Commission, we have identified a number of uses of the information.

For example, last year the Division of Investment Management created its Risk and Examinations Office (“REO”).  REO is a multi-disciplinary office staffed with analysts with strong quantitative backgrounds, along with examiners, lawyers and accountants.  REO intends to conduct rigorous quantitative and qualitative financial analysis of the investment management industry, strategically important investment advisers and funds.  REO, in collaboration with the DERA, is using Form PF data to develop risk-monitoring analytics, as well as to provide internal periodic reports regarding the private fund industry and particular market segments.

Division staff also will use Form PF data to inform policy and rulemaking with regard to private funds, and we intend to use aggregated, non-proprietary data in our consultative work with other securities regulators on issues of mutual interest. Similarly, other divisions are beginning to utilize this data to advance their missions. For example, the Commission’s Asset Management Unit of the Division of Enforcement is working with DERA to develop analytic tools to integrate Form PF data into research and due diligence related to investigative work and other enforcement matters. Also, the OCIE anticipates using the information collected on Form PF for, among other things, conducting pre-examination research and due diligence. 

That said, I know that the hedge fund industry has raised concerns about the confidentiality of Form PF data.  However, I can reassure you that the Commission takes the protection of the confidentiality of this information very seriously.  To comply with enhanced confidentiality provisions established under the Dodd-Frank Act with respect to Form PF, Commission staff has developed a secure filing environment for Form PF to protect the information when and after it is filed.  In addition, we have established an inter-Divisional  steering committee to address internal data use and create a comprehensive policy on access to and use of Form PF data.

Our experience with Form PF data is in its early stages and the utility of the data collection will develop as the collective experience with the information evolves.  Of critical importance to expanding the utility of the data is our confidence in the information provided by filers.  Division staff is proactively trying to improve data quality by, for example, issuing FAQs on interpretive issues that commonly arise from filers – in fact, we most recently updated our FAQs last month.[12]  During this process, the staff has benefited immensely from the open and continuous dialogue with you, and we want to continue that practice.

Industry Outreach

As a complement to the data that we receive, we are working to improve our awareness of the industry through a hands-on outreach initiative.  While data is important for providing census information, identifying aberrational performance and systemic trends, it does not give you a sense of a firm’s culture and approach to compliance.  In order to get a first-hand view of advisers’ systems, controls and culture, REO staff, OCIE leadership and I have met with senior management of many larger, strategically important advisers – many of which have an institutional line of business through which they manage private funds.  Also, our colleagues in OCIE have begun their presence exam initiative, which is part of an outreach to engage directly with newly registered advisers to private funds.[13]  This initiative is focused on five key areas of risk: marketing, portfolio management, conflicts of interest, safety of client assets and valuation.  OCIE is still in the engagement phase of this initiative and expects to report back to the industry at the conclusion of the program.  During a panel later this morning, I believe my colleague from OCIE will be sharing with you some of the preliminary findings and observations from that initiative. 

We hope to continue directly interacting with you and your colleagues, and by working together better ensure that the industry operates in the best interests of clients and fund investors.

Other Regulatory Initiatives

After several years of diligent work, I am happy to report that the Dodd-Frank mandated rulemaking directly related to investment advisers is complete.  While there are outstanding proposals on the Volcker Rule and incentive compensation, each of which may impact investment advisers that charge performance fees and/or accept investments from or are owned by banks or bank sponsored funds, the Division will attempt to turn some of its attention to other regulatory initiatives regarding advisers to hedge and other private funds.

As I have previously announced, one of our longer term initiatives is a review of the rules that apply to private fund advisers.  Although the principles-based Advisers Act regime has largely stood the test of time, despite being applied to an increasingly diverse set of adviser business models, the staff is evaluating whether Advisers Act rules require modernization to reflect the current business and operations of private fund advisers. This initiative has been spurred, at least in part, by the inquiries and feedback that we receive from industry stakeholders, especially from new registrants, and your input helps inform our assessment.  As such, please continue to bring your issues and challenges to our attention.

As one might expect, a review of the Advisers Act regime is no small task and the process, along with any potential rulemaking, will take time to run its course to ensure that we get it right.  That being said, the Division has and will actively consider providing guidance where appropriate.  For example, with respect to the Advisers Act custody rule, we are open to public input on issues and concerns regarding implementation of the rule.  Just last month the Division’s staff issued guidance regarding the application of the custody rule to private stock certificates, which rightly focused on investor protections provided by fund audits.[14]  Although we understand that this guidance may not end our work in regard to the custody rule, it does represent a significant step forward and is an example of our efforts to clarify the application of the rules, while at the same time promoting robust investor protection.

Compliance – Insider Trading

Earlier, I touched upon our outreach initiative designed to get a sense of an adviser’s culture of compliance.  While our experience thus far generally confirms that most investment advisers attempt to do the right thing in fulfilling their regulatory compliance obligations, the recent highly-publicized string of insider trading cases in the hedge fund industry highlights the need for improvement.  During one of today’s panels, you will hear about good practices to improve controls on the misuse of material non-public information, so I will keep my remarks high-level.

To borrow a recent quote from Harvey Pitt, a former Chairman of the Commission, “[w]hen it comes to compliance, you have to live, eat, breathe and drink it.”[15]  This observation is particularly fitting with respect to the prevention of insider trading.  As you know, the Advisers Act requires advisers to establish, maintain and enforce written policies and procedures reasonably designed to prevent misuse of insider information.[16]   In addition, Advisers Act provisions require, among other things, the adoption of a written code of ethics that sets forth standards of business conduct and that requires compliance with federal securities laws. However, the prosecution of alleged insider trading continues to be an area of active enforcement by the Commission.  Indeed, the prevalence of insider trading negatively impacts investor confidence.[17]

In light of these cases, advisers should revisit their compliance policies and procedures and assess whether they effectively provide a comprehensive framework for the identification and prevention of the misuse of non-public information.  In addition, advisers should provide continuous training and guidance to ensure that employees know what to do—or, more importantly, what to refrain from doing—when they come into possession of inside information.

Conclusion

I appreciate the opportunity to share my thoughts on these issues of interest to investment advisers and the larger hedge fund community.  The Division works to protect investors, promote informed decision making, and facilitate appropriate innovation in investment products and services through regulating the asset management industry.  Thank you for your time this morning.

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[1] The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees.  The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or of the author’s colleagues on the staff of the Commission.

[2] See Chair Mary Jo White, Statement at the SEC Open Meeting (July 10, 2013),available at http://www.sec.gov/News/Speech/Detail/Speech/1370539689380.

[3] See Amendments to Regulation D, Form D and Rule 156 under the Securities Act, Securities Act Release No. 33-9416 (July 10, 2013), available athttp://www.sec.gov/rules/proposed/2013/33-9416.pdf.

[4] See Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A Offerings, Securities Act Release No. 33-9415 (July 10, 2013), available at http://www.sec.gov/rules/final/2013/33-9415.pdf.

[5] Id. at 52.

[6] Id.

[7] See Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings, Securities Act Release No. 33-9414 (July 10, 2013), available athttp://www.sec.gov/rules/final/2013/33-9414.pdf.

[8] IARD data as of August 1, 2013.

[9] See Rule Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers Act Release No. 3221 (June 22, 2011), available athttp://www.sec.gov/rules/final/2011/ia-3221.pdf.

[10]  See Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisers, Investment Advisers Act Release No. 3308 (October 31, 2011), available at http://www.sec.gov/rules/final/2011/ia-3308.pdf.

[11] Id. at Section V.A.

[12] See Form PF Frequently Asked Questions, available athttp://www.sec.gov/divisions/investment/pfrd/pfrdfaq.shtml

[13] See Letter from SEC’s Office of Compliance Inspection and Examination to Senior Executive or Principal of Newly Registered Investment Advisers (Oct. 9, 2012),available at http://www.sec.gov/about/offices/ocie/letter-presence-exams.pdf.

[14] See IM Guidance Update – Custody of Privately Offered Securities (August 2013),available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-04.pdf.

[15] James B. Stewart, At SAC, Rules Compliance With an ‘Edge’, NY Times (July 26, 2013), quoting Harvey Pitt. 

[16] Section 204A of the Advisers Act.

[17]U.S. Securities and Exchange Commission Press Release: SEC Charges Steven A. Cohen With Failing to Supervise Portfolio Managers and Prevent Insider Trading (July 19, 2013), available athttp://www.sec.gov/News/PressRelease/Detail/PressRelease/1370539726923;  U.S. Securities and Exchange Commission Press Release, SEC Charges Former Portfolio Manager at S.A.C. Capital with Insider Trading (July 25, 2013), available athttp://www.sec.gov/litigation/litreleases/2013/lr22761.htm; U.S. Securities and Exchange Commission Press Release, SEC Charges Dallas-Based Trader with Front Running (May 24, 2013), available athttp://www.sec.gov/litigation/litreleases/2013/lr22707.htm.;  U.S. Securities and Exchange Commission Press Release, SEC Charges Sigma Capital Portfolio Manager with Insider Trading (Mar. 29, 2013), available athttp://www.sec.gov/news/press/2013/2013-49.htm.

CFTC CHILTON'S STATEMENT TI CFTC TECHNOLOGY ADVISORY COMMITTEE

FROM:  COMMODITY FUTURES TRADING COMMISSION 

"Hot Mess"

Statement of Commissioner Chilton to the CFTC Technology Advisory Committee

September 12, 2013

Thank you, Chairman O'Malia and thank you to the Technology Advisory Committee (TAC) members for your participation.

Technology in markets is way cool. All sorts of new and gee whiz things have been developed. The high frequency cheetah traders are killing it. I just want to ensure that they don't kill other traders, like end users, or markets or consumers.

There are some basic things that should be done now. They can't wait for a year. In fact, I hope we move on some of these things this year.

One—Registration;

Two—Testing;

Three—Kill Switches; and

Four—Wash Sales; we need to ensure that wash sales are prohibited and that the exchanges mandate that wash blocking technologies are used by traders. I'm pleased that IntercontinentalExchange (ICE) is adopting such a policy.

I look forward to our discussion.

Thank you Mr. Chairman.

FINAL JUDGMENT ENTERED AGAINST TRUE NORTH FINANCE CORPORATION FOR OVERSTATEING INTEREST REVENUE

FROM:  SECURITIES AND EXCHANGE COMMISSION 
Final Judgments Entered Against Cfo and Real Estate Finance Company

The Securities and Exchange Commission announced that on September 11, 2013, a Minnesota federal court entered final judgments by consent against Owen Mark Williams (Williams) and True North Finance Corporation, f/k/a CS Financing Corporation (True North), in a civil injunctive action filed by the Commission on September 21, 2010. Among other things, the judgment against Williams requires him to pay a $40,000 civil penalty.

The Commission's complaint alleged that True North and its Chief Financial Officer, Williams, overstated revenue in True North's filings with the Commission in 2008 and 2009. Williams caused True North to improperly recognize revenue on interest from borrowers where the borrowers were not paying True North and where the borrowers' impaired financial condition meant that collectability was not reasonably assured. The Complaint alleged that this recognition of revenue departed from generally accepted accounting principles and also departed from True North's revenue recognition policy, which stated that the company would not recognize revenue when the payment of interest was 90 days past due.

The final judgments against Williams and True North also imposed permanent injunctions prohibiting these Defendants from violating of Section 17(a)(2) of the Securities Act of 1933 (Securities Act), Sections 13(b)(2)(A), 13(b)(5), and 15(d) of the Securities Exchange Act of 1934 (Exchange Act), and Rules 13b2-1, 13b2-2, 13b-20, and 15d-14 thereunder.