House Passes Three Financial Services Bills

The House passed three financial services bills concerning: (i) angel investors (H.R. 4854: “Supporting America’s Innovators Act of 2016”), (ii) retail investor participation in crowdfunding (H.4. 4855: “Fix Crowdfunding Act”) and (iii) the prevention of financial abuse of senior citizens (H.R. 4538: “Senior$afe Act of 2016”).

H.R. 4854: The Supporting America’s Innovators Act of 2016 amends the Investment Company Act to exempt from coverage any issuer whose outstanding securities with respect to a qualifying venture capital fund (other than short-term paper) are beneficially owned by not more than 500 persons. The bill also defines qualifying venture capital fund as one that does not purchase more than $10 million (annually adjusted for inflation) in securities of any one issuer.

H.R. 4855: The Fix Crowdfunding Act amends:

  • the Securities Act to increase from $1 million to $5 million the aggregate amount of securities sold to all investors by an issuer that qualifies for the crowdfunding exemption from certain prohibitions relating to interstate commerce;
  • the JOBS Act to permit crowdfunding portals to disqualify issuers from offering securities through the portal if they discover through a background check that an issuer has made an untrue statement of a material fact, omitted to state a material fact necessary to avoid making misleading statements, or engaged in fraud or deceit;
  • the Securities Exchange Act to exempt crowdfunding securities transactions from its registration requirement; and
  • the Investment Company Act to: (i) exempt from the definition of investment company any issuer that, for the purpose of making a crowdfunding offering, holds the securities of not more than one issuer eligible to offer securities (a single-purpose fund); and (ii) permit an issuer, before commencing a crowdfunding offering, to solicit non-binding indications of interest from potential investors in the prospective offering under certain conditions.

H.R. 4538: The Senior$afe Act would provide new protections for financial institutions and certain of their employees (supervisors, compliance officers and legal advisors) that report suspected exploitation to authorities in the accounts of clients over the age of 65.

Lofchie Comment: For crowdfunding portals to work, Congress must provide a way for them to make money without being subject to such heavy regulatory requirements imposed by the SEC and FINRA. Otherwise, it’s simply hard to see the incentive for a crowdfunding portal to operate. Below, for example, is a list of the activities that a funding portal cannot engage in (read it and please explain why anyone would want to start one):

(a) provide advice or make recommendations;

(b) solicit transactions in the securities displayed on the portal;

(c) receive any compensation or pay its employees in connection with the sale of securities;

(d) hold securities;

(e) provide compensation to those who identify potential investors; or

(f) allow its directors or officers to have a financial interest in any issuer using the portal.

See generally Lofchie’s Guide to Broker-Dealer Regulation — Registration Requirement.

Streetwise Professor Questions Regulators’ Ability to Prevent Next Financial Crisis

University of Houston Finance Professor Craig Pirrong questioned a policymaking assumption that better understanding of the workings of financial networks can enable regulators to make financial markets better and, therefore, prevent the next financial crisis. He cited mandatory clearing and rigid variation margin requirements as examples of regulatory measures that change the topology of a financial network to “make the network more tightly coupled, and therefore more vulnerable to precipitous failure.”

Professor Pirrong criticized policymakers who believe that they can reconfigure highly interconnected financial networks to make them safer, arguing that “[t]he very features – feedbacks, spillovers, non-linearity’s – that can create suboptimality also make it virtually impossible to know how any intervention will affect that network, for better or worse, under the myriad possible states in which that network must operate.” He concluded that:

 . . .it is delusional to think that simplicity can be “imposed on” a complex system like the financial market. The network has its own emergent logic, which passeth all understanding. The network will respond in a complex way to the command to simplify, and the outcome is unlikely to be the simple one desired by the policymaker.


Lofchie Comment: Professor’s Pirrong’s financial network models demonstrate how complexity may thwart the most well-intentioned regulatory plan. A couple of related observations:

First, many elected officials and regulators are so invested in Dodd-Frank and the regulations adopted under it, that they deny its deficiencies or the problems it creates. See, e.g.Legislators Boast That Shrinking Size of GE Capital Proves Dodd-Frank Is a SuccessFDIC Chair Gruenberg Asserts that Post-Crisis Reforms Strengthen the Financial System. Even to those who believe that Dodd-Frank is a better than bad piece of legislation, honest and critical examination would demand significant revision. No one can write a 2,000-page piece of legislation that would not benefit from a second draft.

Second, regarding an observation made by former SEC Commissioner Daniel Gallagher: FSOC’s recent report on risks to the financial system entirely (with the exception of one clause) missed Brexit. If this were the NBA, that would be the equivalent of missing Kevin Durant going to the Warriors.

Given the Professor’s warnings about the impact of complexity on any system, maybe a little more modesty and willingness to be self-critical are in order.

An Evaluation of the SEC’s Admissions Policy

Since the establishment of the SEC’s Division of Enforcement in the 1972, the SEC has routinely allowed defendants to settle enforcement actions without admitting fault.  In the standard settlement language, a defendant neither admits nor denies wrongdoing, which means that the settlement cannot be used against the defendant in parallel proceedings, such as shareholder class action litigation and government contract debarment proceedings, but at the same time, the defendant may not publicly deny the SEC’s charges.  The neither-admit-nor-deny concept grew out of the practical reality that the SEC’s Enforcement Staff would be more likely to obtain a settlement and thus conserve SEC resources that could be used to protect other investors if the Enforcement Staff did not insist that defendants admit wrongdoing, which itself could have damaging collateral consequences, particularly with respect to public companies and their shareholders.

With the greater emphasis in the last five years on punishing wrongdoers, the SEC announced in 2012 that it would require defendants to admit liability in settlements where defendants also had pleaded guilty in related criminal actions.  The theory was that the defendant already had pleaded criminally guilty to essentially the same conduct at issue in the SEC’s civil action, and thus the defendant would have few, if any, additional concerns with admitting fault in the SEC’s settlement.

The SEC greatly expanded the admissions concept in 2013.  On June 18, 2013, SEC Chair Mary Jo White announced that the SEC would seek more often admissions of wrongdoing from individual and corporate defendants as a condition of settling enforcement cases.[1]  In a speech delivered on September 26, 2013, Chair White outlined the types of cases where the Commission, in its discretion, might seek an admission of wrongdoing, which include cases where:

  • A large number of investors have been harmed or the conduct was otherwise egregious.
  • The conduct posed a significant risk to the market or investors.
  • Admissions would aid investors deciding whether to deal with a particular party in the future.
  • Reciting unambiguous facts would send an important message to the market about a particular case.[2]

As this expanded admission policy was being implemented, the Director of Enforcement stated that the SEC would not consider the collateral consequences to an individual or entity when determining whether to seek an admission.  That means, for example, that the SEC would not consider the impact to shareholders of additional payouts in costly plaintiff litigation and would not consider the increased potential for debarment of government contractors after admitting wrongdoing to the SEC.  In contrast, the Department of Justice when seeking to impose corporate criminal liability must consider the collateral consequences to the company.

The SEC’s expanded admission policy has created three primary concerns.  First, the admissions policy marks a fundamental shift in emphasis from protecting investors to punishing wrongdoers.  While this distinction may appear at first glance to be academic in nature, it has very real consequences.  The SEC, as a regulatory agency, has as three-part mission:  Protect investors; maintain fair, orderly and efficient markets; and facilitate capital formation.  The admission policy may be at odds with the concept of protecting investors and facilitating capital formation.  Indeed, protecting investors may mean that, under certain circumstances, alleged wrongdoers receive a lesser sanction from the SEC in an effort to ensure that shareholders and investors do not suffer additional, collateral consequences for alleged wrongdoing.  For a public company, greater exposure to shareholder litigation and potential loss of valuable government contracts through admitting wrongdoing in a settlement with the SEC harms shareholders, who ultimately shoulder SEC corporate penalties, settlements with plaintiffs, and loss of shareholder equity in the case of debarment from lucrative government contracts.  While those outcomes might be appropriate in some instances, would it be more appropriate for the Commission to consider those outcomes in determining whether to seek an admission?

The second concern with the SEC’s admission policy is the lack of clear guidance and the disproportionate impact on some defendants.  The admissions policy may allow for subjective application without considering the individualized conduct of the defendant.  Although the admission policy is rooted in punishing the wrongdoer, the stated standards are not focused on evaluating the circumstances of the alleged wrongdoer.  And while the SEC purports to be focused on protecting “investors” and the market as a whole, the collateral consequences to shareholders of the alleged wrongdoer company are not even considered.

Finally, the admissions policy is susceptible to being used directly or indirectly as a negotiating tool for greater penalties.  This form of leverage could take the form of the SEC Enforcement Staff making overtures that, if a defendant were to agree to a higher penalty, the Enforcement Staff would not push for an admission.  Or the Enforcement Staff might be less direct and instead say that they are still considering whether to seek an admission but would be open to a settlement offer.  Regardless of the form it takes, leaving any discretion to the Enforcement Staff to seek an admission directly or indirectly increases the Enforcement Staff’s leverage for higher penalties.  The mere threat that the Enforcement Staff might seek the dreaded admission may result in defendants offering to settle for greater penalties than without that threat.

One possible solution may be to remove any discretion from the Enforcement Staff and place that discretion into the hands of the Trial Unit to evaluate whether the evidence is so strong that they would risk taking the matter to trial.  Another possible solution may be for the Enforcement Staff to determine from the Commission at the start of settlement negotiations whether the Commission would insist on an admission of wrongdoing.  That course would enable to the parties to negotiate under the same understanding of whether an admission is, in fact, likely to be sought.

One thing is clear.  The SEC’s admission policy requires some rethinking.

The Center for Financial Stability (CFS) is a private, nonprofit institution focusing on global finance and markets. Its research is nonpartisan. This publication reflects the judgments and recommendations of the author(s). They do not necessarily represent the views of Members of the Advisory Board or Trustees, whose involvement in no way should be interpreted as an endorsement of the report by either themselves or the organizations with which they are affiliated.



Legislators Boast That Shrinking Size of GE Capital Proves Dodd-Frank Is a Success

Senator Sherrod Brown (D-OH) and Representative Maxine Waters (D-CA) asserted that the rescission by the Financial Stability Oversight Council (“FSOC”) of the systemically important financial institution (“SIFI”) designation of the General Electric Capital Corporation (“GECC”) proves that “FSOC is working just as Wall Street Reform intended: to protect working Americans from once again bailing out ‘too-big-to fail’ institutions.”

In a joint statement, the legislators asserted that SIFIs must choose between emphasizing oversight or stability:

The Council’s action shows that “systemically important” firms have a clear choice between stricter oversight or reducing their threat to taxpayers and financial stability.


Lofchie Comment: Facts belie the legislators’ political assertion that Dodd-Frank has had the effect of shrinking big firms and increasing market share for smaller firms. A look at the three most significant types of Dodd-Frank-regulated financial intermediaries: banks, broker-dealers and futures commission merchants (“FCMs”) makes this clear:

  • In the case of FCMs, CFTC Commissioner J. Christopher Giancarlo provides the statistics: “[T]he number of FCMs has dramatically fallen in the past 40 years: from over 400 in the late 1970s, to 154 before the 2008 financial crisis, and down to just 55 active firms serving customers today. As the number of FCMs has dwindled, systemic risk has increased, with the five largest firms accounting for more than 70 percent of the market.” See CFTC Commissioner Giancarlo Warns of Threat Posed by ‘Increasing Ill-Conceived Regulatory Burdens’.”
  • In the case of broker-dealers, FSOC reports that the number of firms has declined steadily from approximately 4900 in 2009 to under 4200 in 2015 (see Chart 4.12.1 of FSOC’s 2016 Annual Report).
  • In the case of banks, concentration in the industry has increased materially. The FDIC‘s statistics indicate that since 2009, the number of commercial banks has declined from 6,829 to 5,289, and that a similar decline has occurred in the number of savings institutions.

In short, Dodd-Frank decreased the actual number of financial institutions and increased concentration in the financial industry. From an economic standpoint, this outcome is not surprising; a material increase in fixed costs, whether regulatory or otherwise, drives smaller firms either out of business or toward acquisition.

The legislators’ argument, that forcing GECC to shrink by means of heavy regulation is a good thing, is troublesome for other reasons as well. It simply does not provide a complete view of the costs inherent in heavy regulation. The conclusion fails to consider, for example, the loss of former GECC jobs, with all the attendant consequences that brings, such as a real reduction in social services. Making the argument that the shrinking of GECC is a good thing requires – at a minimum – an acknowledgement of these trade-offs.

A troubling political narrative has overtaken an objective assessment of recent financial regulation. Many have become so invested in defending Dodd-Frank that they cannot even acknowledge, let alone bring themselves to say, that parts (perhaps even large parts) are not working as intended. No one is boasting about the increased concentration in the financial sector since the adoption of Dodd-Frank.