The following excerpt is from the SEC website:
Keynote Address
Investment Adviser Association Investment Adviser Compliance Conference/2012
by Commissioner Daniel M. Gallagher
U.S. Securities and Exchange Commission
Investment Adviser Association Investment Adviser Compliance Conference/2012
Arlington, VA
March 8, 2012
I want to thank David [Tittsworth] for inviting me to speak at this conference today. It is both an honor and a pleasure to speak to you this morning. The regulatory landscape for investment advisers has changed dramatically in the past two years, and programs like this one help ensure that we are all thinking hard about the consequences of this ongoing upheaval.
Before I begin my remarks, I must make clear that my comments today are my own, and do not necessarily represent the positions of the Commission or my fellow Commissioners.
As you are well aware, Congress passed the Dodd-Frank Act in July 2010, ushering in a sea change in the landscape of financial regulation. It may feel to you as if much of this regulatory change has already occurred, but in reality we have only begun to feel its effects. According to one law firm, the SEC has finalized only 18 of the 98 rules mandated by Dodd-Frank. Additionally, Dodd-Frank required rulemaking by our sister financial regulatory agencies as well, and their work is also ongoing. As a side note, let me state unequivocally that I do not regard missing Dodd-Frank deadlines as a failure by any of the relevant agencies, including the SEC. Indeed, I am pleased that the Commission is moving deliberately in promulgating these complicated and novel rules, which will have vast implications for U.S. markets and market participants. Nonetheless, it is evident that the Commission and the markets will be working through the implications of Dodd-Frank for years to come.
Despite (or perhaps because of) the Commission’s willingness to move slowly, Dodd-Frank has come to dominate the SEC’s regulatory calendar and is likely to continue to do so for some time. But as we follow through on Dodd-Frank implementation, the Commission must be careful not to lose its perspective. When Congress passes a new law, even one as sweeping as Dodd-Frank, it does so against a backdrop of existing laws and regulations and interpretations. In other words, Dodd-Frank does not exist in a vacuum. And although it explicitly amended our existing securities laws, the unamended portions of those laws continue to bind and guide the Commission in the exercise of its authority. Indeed, the agency has been administering these laws for decades, building up a deep reservoir of expertise and experience in regulating the securities markets. This knowledge and experience has been hard won: as we move forward with the bulk of our Dodd-Frank rulemakings, we should not turn away from that history.
First, and most importantly, Dodd-Frank did not change the fundamental mission of the Commission: to protect investors; to maintain fair, orderly, and efficient markets; and to facilitate capital formation. Each and every one of our regulations – whether promulgated pursuant to Dodd-Frank or not – should be consistent with this tripartite mission.
Second, the Commission’s regulatory program diverges in important ways from the programs of our sister regulators. We are not prudential regulators. We do not regulate with “safety and soundness” as our ultimate goal. And, contrary to the perceptions of some, we are not systemic risk regulators. Dodd-Frank created the Financial Stability Oversight Council (FSOC) to take on that systemic risk role, and although the SEC Chairman is a member of the FSOC, the Commission is not. Given the SEC’s mission and the nature of investing in securities, the Commission cannot –and should not—endeavor to eliminate risk-taking. Attempting to empty securities products of all risk would be a fool’s errand and, if successful, would likely empty such products of all return as well. Putting this point another way, it is impossible to prevent all investment losses without also preventing all investment profits.
Let me focus on that for a moment. While our core mission is to protect investors, the securities laws and the Commission have historically recognized that there are many types of investors, some of whom require the full protection of the securities laws, and some who do not. Specifically, our laws and regulations draw distinctions among, for example, retail, institutional, sophisticated, accredited, and non-accredited investors, not to mention qualified clients. Innumerable regulations recognize that not all investors should be treated the same, as it means something different to “protect” a retail investor than it does to “protect” a sophisticated, institutional investor.
The notion of the sophisticated investor is most pertinent in the context of private securities offerings. In 1953, the Supreme Court analyzed the scope of the private placement exemption to the Securities Act of 1933. The Court, finding little explicit guidance in the statute’s legislative history, looked to the purpose of the ’33 Act. It explained that “[t]he design of the statute is to protect investors by promoting full disclosure of information thought necessary to informed investment decisions.”1 As a result, the Court reasoned, the availability of the registration exemption “should turn on whether the particular class of persons affected need the protection of the Act.”2 This tiered approach to whether the full protections and restrictions of the securities laws should apply to particular classes of investors is evident elsewhere in our regulations, as well.
For example, although there is a general prohibition on advisers charging performance fees to investors, the Commission has allowed for certain exemptions to that prohibition. Originally, the Commission used its general exemptive authority under Section 206A of the Investment Advisers Act of 1940 to permit certain performance fee arrangements.3 Congress ultimately recognized the need for this exemptive relief, and amended the Advisers Act to include Section 205(e), which allowed the Commission to exempt any person from the prohibitions on performance fee arrangements if it determined that the person did not need the protections of the securities laws “on the basis of such factors as financial sophistication, net worth, knowledge of and experience in financial matters, amount of assets under management, relationship with a registered investment adviser, and such other factors as the Commission determines are consistent with this section.” The Commission recently used this Section 205(e) exemptive authority to amend existing exemptive relief in the performance fee area.4
In my view, the Commission’s tiered approach to the varied levels of investor sophistication is thoughtful and appropriate. As both Congress and the Supreme Court have recognized, not all investors need the fullest protections of the securities laws. Indeed, in many instances, investors with a significant degree of sophistication would prefer to trade away some of the requirements of the securities laws in exchange for greater freedom in investment selection.
This dynamic is also relevant to our duty to consider the costs and benefits of the regulations that we promulgate. With respect to regulated entities such as broker-dealers and investment advisers, our regulations impose costs, which, in turn, are passed on to investors. Where regulations are designed to protect investors who are not sophisticated enough to “fend for themselves,” in the words of the Supreme Court, and if the imposition of costs on regulated entities is necessary, then it is only right that the Commission act. But where such costs are not necessary, then refraining from imposing such costs is the appropriate course for the investors who would foot the bill, and such a course is consistent with the Commission’s obligation to maintain fair and efficient markets and to foster capital formation.
I worry that, in the aftermath of the financial crisis, the Commission may be moving away from its long-established sensitivity to these distinctions. While it is true that many institutional and sophisticated investors suffered losses during the crisis, the Commission should not abandon these carefully considered distinctions. To regulate as if all investors are alike may lead the Commission to impose massive costs on the system without a purpose that is consistent with the Commission’s mission and its decades of experience.
Indeed, this danger is particularly acute in the Dodd-Frank space. As I mentioned previously, Dodd-Frank contains an array of broad statutory mandates, some of which are nominally intended to provide additional investor protections. While it might seem easy to take each Dodd-Frank mandate as it comes and to treat all potentially affected investors uniformly when regulating, such an approach would be simplistic and counterproductive. Instead, we must continue to be thoughtful about the interests of the investors we are trying to protect, and whether – in our rush to regulate in the name of enhanced investor protection – we have not only failed to protect investors in any meaningful way, but have actually harmed them by reducing the choice of investments available to them, by deterring capital formation, or by disrupting otherwise fair, orderly, and efficient markets.
Let me offer you a specific example. As I am sure all of you here know, the Dodd-Frank Act eliminated the exemption from registration for advisers with 15 or fewer clients. This was Congress’s attempt to address what it viewed as a problem in the financial markets: namely, the existence and practices of highly leveraged hedge funds. As a result, many private fund advisers are undergoing the process of registering for the first time with the Commission. I was not here at the Commission when the registration regime for these advisers was being crafted, but I have had many meetings with various private fund advisers who are alarmed at the looming costs and unintended consequences expected to flow from the wholesale imposition of our existing registration regime on previously unregistered advisers.
Over the past few months, I have met with several representatives from advisers that do not use leverage as part of their business strategy and market only to sophisticated and institutional investors. The rationale for imposing the full weight of our registration regime on such advisers is questionable, and, historically, the Commission has conserved its resources by allowing the sophisticated clients of such advisers to police the conduct of their advisers privately. But now such advisers must bear the burden of the ongoing compliance costs that come with Commission registration and reporting on Form PF. This will impose significant costs and burdens not only on the private advisers, but also on the Commission. And yet, this expansion of our regulatory reach will not serve to protect ordinary retail investors, but rather investors who could, as the Supreme Court so notably said, “fend for themselves.”
Additionally, it is likely that these higher costs will threaten the ability of certain funds – such as certain private equity funds – to promote capital formation through investments in operating companies. And let me be clear: capital formation leads to job creation, which is something we could certainly use right now. Even more troubling is that these new costs are not likely to yield materially enhanced protections for the private funds’ investors. Indeed, in many instances, all investors in a given private fund are sophisticated enough and possess enough bargaining power to ensure adequate disclosure and other protections as a condition of their investment. Indeed, in at least some cases, these new registration requirements will do nothing more than have the unintended consequence of draining much-needed resources from funds.5
So, what can we do? Let me return to my original thesis that Dodd-Frank does not exist in a vacuum. Except in very rare circumstances, the Commission may always use its exemptive authority to mitigate the unintended consequences of its rulemaking. Thus, for example, the Advisers Act – as I mentioned previously – explicitly provides that “[t]he Commission . . . may conditionally or unconditionally exempt any person or transaction, or any class or classes of persons, or transactions, from any provision or provisions of this title or of any rule or regulation thereunder, if and to the extent that such exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this title.”
This clear grant of authority to the Commission was not revoked by Dodd-Frank. The Commission is free to use this exemptive power, in its discretion, to temper the effects of statutory provisions and regulations promulgated thereunder. Indeed, in its role as an expert regulator, the Commission has an obligation to read any specific statutory provision in harmony with its overarching mission to protect investors, maintain fair, orderly, and efficient markets, and to facilitate capital formation. The careful consideration and use of the Commission’s exemptive power is part and parcel of this obligation.
When discharging the legislative commands of Dodd-Frank, the Commission retains significant discretion as to how to best accomplish the act’s purposes. Crucially, the responsible exercise of that discretion requires the Commission to know when to restrain its regulatory hand. Thus, I believe that it is appropriate for the Commission, when engaging in rulemaking, to use its exemptive authority to ensure that we harmonize a particular statutory mandate with our larger regulatory missions.
Let me reiterate that this should not become an effort to undercut or frustrate Congressional intent. The Commission must always keep in sight the purposes underlying the particular legislative language that drives our regulations. But we would abdicate our obligations as an expert agency if we did not strive to create the best regulations possible, in light of all our statutory mandates.
Returning to my particular example of private fund adviser registration, I believe that there will be cases, moving forward, when an individual adviser or a particular class of advisers ought to be granted some measure of relief from the full panoply or requirements that come with registration under the Advisers Act. Although there are many factors that should be taken into account when constructing exemptive relief – and I do not wish to suggest that any one criterion is necessary or sufficient – I am particularly interested in ensuring that the Commission’s investor protection rationales for registration are not twisted and taken to the illogical conclusion that “one size fits all.” As I hope I have made clear, I believe that the protections of the securities laws should be appropriately scaled to the needs to various classes of investors. The Commission has repeatedly recognized this principle, and the Supreme Court has validated it, to the benefit of both investors and the markets. We must not turn our backs on this history.
Switching gears, I’d like to discuss one other topic that may be of particular interest to this audience: namely, the extent of “failure to supervise” liability for compliance and legal personnel. As you know, the Advisers Act permits the Commission to sanction a person associated with an investment adviser if such person “has failed reasonably to supervise, with a view to preventing violations of the provisions of such statutes, rules, and regulations, another person who commits such a violation, if such other person is subject to his supervision.”6 The Commission has similar powers over persons associated with a broker or dealer, and there is a long line of failure-to-supervise cases in the broker-dealer context.
In 1992, the Commission issued a rare Section 21(a) report in connection with In re John H. Gutfreund, an administrative proceeding involving several senior executives at a prominent broker-dealer.7 In that report, the Commission noted that although legal and compliance personnel are not automatically deemed to be supervisors, they could become supervisors if members of senior management involve them in responding to a regulatory problem. As the Commission stated, “determining if a particular person is a ‘supervisor’ depends on whether, under the facts and circumstances of a particular case, that person has a requisite degree of responsibility, ability or authority to affect the conduct of the employee whose behavior is at issue.”
Recently, the Commission considered a case regarding a broker-dealer general counsel’s alleged supervision of a rogue trader in light of the factors set forth in Gutfreund. In the Initial Decision in that case, 8 one of the SEC’s Administrative Law Judges (ALJ) found that the general counsel did not have traditional supervisory authorities as to the rogue trader, such as the power to direct the trader’s activities, and did not consider himself to be the rogue trader’s supervisor. Despite these findings, the ALJ concluded that the firm’s general counsel was a supervisor under the Gutfreund standard, citing the authoritativeness of his legal and compliance opinions and recommendations, his membership on the firm’s credit committee, and the fact that he dealt with the rogue broker on behalf of that committee. Fortunately for the respondent, the ALJ held that the general counsel had not failed in his duties as a supervisor, and in any event the Commission subsequently dismissed the proceeding altogether.9 Nonetheless, the finding that a general counsel could be deemed the supervisor of an employee in a business unit is a sobering one.
So what lessons can be drawn from this line of cases? What Gutfreund and similar proceedings appear to hold is that once a person becomes involved in formulating management’s response to a problem, he or she is obligated to take affirmative steps to ensure that appropriate action is taken. And although the functions and responsibilities of legal and compliance personnel vary from firm to firm, they generally do include responding to potential violations of law; moreover, we at the Commission have repeatedly encouraged legal and compliance personnel to promote a “culture of compliance” through active, visible engagement with management and employees.
However – and this is quite unfortunate – that sort of robust engagement on the part of legal and compliance personnel puts them at risk of being deemed to be “supervisors” subject to liability for violations of law by the employees they are held to be supervising. This creates a dangerous dilemma. A compliance officer or in-house attorney who stays ensconced in a dark corner of the firm avoiding engagement on difficult regulatory issues would minimize his risk of supervisory liability, but he would not be contributing much to the firm’s culture of compliance. By contrast, the more engaged a firm’s legal counsel or compliance personnel become — the more they bring their expertise to bear in addressing important, real-world compliance issues and in providing real-time advice for concrete problems faced by firms and their employees — the more they incur a risk of supervisory liability.
Deterring such engagement is contrary to the regulatory objectives of the Commission. Over the past several decades, investment advisers have created robust functions dedicated to formulating policies and assisting management in creating a culture of compliance, and this has had a profoundly positive effect on investor confidence. Once again, I want to stress that firms and investors are best served when legal and compliance personnel feel confident in stepping forward and engaging on real issues. Deterring such active involvement will erode investor confidence in firms, to the detriment of all.
Continuing uncertainty as to the contours of supervisory liability for legal and compliance personnel will have a chilling effect on the willingness of such personnel to provide the level of engagement that firms need and that the Commission wants. In resolving this uncertainty, we should strive to avoid attacking or penalizing the willingness of compliance and legal personnel to be fully involved in firms’ responses to problematic actors or acts. To put it simply, if a firm employee in a traditionally non-supervisory role has expertise relevant to a compliance matter, that employee shouldn’t fear that sharing that expertise could result in Commission action for failure to supervise.
The Commission’s ability to impose sanctions for failure to supervise is a powerful tool to compel an investment adviser’s managers and executives to proactively monitor subordinate employees’ compliance with laws and regulations. Those high-level personnel have the authority to direct the conduct of their subordinates, and failure-to-supervise liability can therefore logically serve as a key incentive for a firm’s managers to carry out their responsibilities appropriately. Legal and compliance personnel, however, are a different story. They are, by nature, not supervisors but rather providers of support for the firm’s other employees. The business of regulated entities inherently involves regulatory issues at every turn, and, accordingly, the Commission should want legal and compliance departments involved in the discussion of most issues. We must strive to ensure that failure-to-supervise liability never deters legal and compliance personnel from diving into the firm’s real-world legal and compliance problems. To steal a line from Jack Nicholson in A Few Good Men: We want you on that wall; we need you on that wall!
Again, thanks to David for having me here today, and thank you for your attention. I’m happy to take a few questions.”
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