About Steven Lofchie

Steven Lofchie is Senior Fellow of Legal Studies at the Center for Financial Stability and Co-chairman of the Financial Services Department at Cadwalader, Wickersham & Taft LLP.

SEC Commissioner Urges SEC to Conduct Review of Mutual Fund Regulations

SEC Commissioner Hester M. Peirce urged the SEC to scrutinize and potentially eliminate costly regulations that hinder mutual funds’ ability to generate returns and thus negatively impact investors.

In a speech before the 2018 Mutual Funds and Investment Management Conference, Ms. Peirce argued that the SEC should pay careful attention to the costs and time burdens of complying with rules. Ms. Peirce suggested that the SEC should conduct retrospective reviews of its regulations to assess (i) whether the rules are accomplishing their intended objectives, and (ii) if there are more cost-effective alternatives than the rules currently in place.

Ms. Peirce highlighted that the SEC recently conducted a review of ICA Rule 22e-4, which addresses fund liquidity, before it took full effect. The SEC learned that, among other problems, the liquidity classification requirements in ICA Rule 22e-4 did not accommodate different types of funds and required difficult judgment calls in several instances. Ms. Peirce counseled regulators to remember that funds are not banks and should not be regulated as such.

Ms. Peirce also encouraged the SEC to amend rules to provide investors with disclosure in an easily accessible, readable format. She suggested that the SEC should harness technology to improve fund disclosures. In particular, she advocated for adopting proposed ICA Rule 30e-3, which would allow shareholder reports to be transmitted over a website.

Finally, Ms. Peirce emphasized the need for a rulemaking on ETFs, echoing comments by the Director of the Division of Investment Management (covered here).

Lofchie Comment: There may be no other place in regulation where the tension between (i) adopting regulations that protect retail investors and (ii) imposing regulatory costs that are passed on to retail investors is so obvious. Over time, it seems that regulators tend to focus more and more on investor protection and to ignore the costs. It is important to revisit the trade-offs, as Commissioner Peirce urges.

SEC Director of Investment Management Says Rulemaking on ETFs a “High Priority”

SEC Division of Investment Management Director Dalia Blass emphasized the need for SEC rulemaking on exchange-traded funds (“ETF”), noting that the ETF market is a $3.5 trillion market “operating under more than 300 individually issued exemptive orders.” Ms. Blass’s remarks were delivered at the ICI 2018 Mutual Funds and Investment Management Conference.

Among other recommendations, Ms. Blass urged a reconsideration of the nomenclature currently used to describe key terms. She argued that basic terms like “ETFs” and “index providers” are being used in a manner that is different from their original meanings and have become confusing to investors. Ms. Blass noted that the term ETF is used to encompass commodity pools and exchange-traded notes as well as SEC-registered investment companies. She also challenged some common assumptions about “index providers” including the notion that they may rely on the publisher’s exclusion from the definition of “investment adviser.”

Additionally, Ms. Blass argued that recent developments, particularly with regard to bespoke or narrowly focused indices, appear to have “moved certain index providers away from what we might think of as publishers.” Ms. Blass advised industry professionals to review these terms and provide feedback as to whether they are being used appropriately.

Lofchie Comment: Ms. Blass’s statements are a good example of the SEC focusing on the basics: regulating large scale public markets, seeking to protect public investors, and establishing rules that are of broad general application. Given the size of the market, it makes sense for the SEC to take on rulemaking with respect to ETFs. In fact, it raises a question as to whether the Investment Company Act itself should be amended to provide statutory recognition of the product.

SEC Commissioner Highlights Cybersecurity as Serious Corporate Governance Issue

SEC Commissioner Robert J. Jackson, Jr. highlighted the increasing prevalence of cybercrime and its detrimental effect on public companies, citing over 1,000 incidents in 2016 alone that cost American companies more than $100 billion. Consistent with recent enhanced guidance on cybersecurity risks and disclosure obligations issued by the SEC, Commissioner Jackson encouraged collaboration between corporate counselors and the SEC to develop (i) proactive measures to combat cybercrime and to ensure timely and transparent disclosures following data breaches, (ii) corporate frameworks that discourage insider trading, and (iii) internal reporting structures to enable company boards and management to react.

When a security breach occurs, Commissioner Jackson emphasized the necessity of reporting it to the public quickly. In the absence of timely disclosure, he warned that companies may ultimately face prosecution, pay significant settlements, and suffer reputational harm.

To prevent insider trading, Commissioner Jackson said that senior management should be aware that trading on breach-related information before the breach has been disclosed could be fraudulent. Since the law is less clear regarding non-insiders trading on material nonpublic information, he expressed concern that hackers may be able to profit by making strategic trades after they have executed a cyberattack but before the public has learned about it. To prevent this type of misconduct, Commissioner Jackson said that timely public disclosure must be prioritized in the wake of any cyberattack.

Commissioner Jackson also stressed how vital it is for public companies across all industries to build effective internal cybersecurity controls. In addition to cyber-oriented corporate policies and procedures, Commissioner Jackson urged Congress or the SEC to take further action to address the issue of corporate insider trading in the cybersecurity context.

House Committee Reviews Regulation of Cryptocurrencies and ICOs

At a U.S. House Financial Services Committee hearing, witnesses outlined their recommendations for Congress concerning the regulation of cryptocurrencies and initial coin offering (“ICO”) markets.

Mike Lempres, Chief Legal and Risk Officer at Coinbase, touted the potential of ICOs and expressed support for the “responsible regulation” of such offerings. However, he criticized “regulation by enforcement,” arguing that it can stifle innovation and inhibit progress. Mr. Lempres called for clear and consistent guidance from regulators, including definitive guidelines on the classification of cryptocurrencies as securities or commodities. He also called for increased coordination between regulatory agencies, and warned that investments are likely to move to other countries absent the development of a clear and comprehensive regulatory framework.

Dr. Chris Brummer, Professor of Law at the Georgetown University Law Center, said that a robust disclosure system for ICOs is important to ensure investor protection. He recommended that policymakers require an ICO to disclose (i) a promoter’s location and contact information, (ii) a technological problem and proposed solution, (iii) a description of the token, (iv) qualifications of the technical team, and (v) industry risk factors.

Peter Van Valkenburgh, Director of Research at Coin Center, urged Congress to consider establishing a federal framework rather than relying on a state-by-state approach for regulating cryptocurrency exchanges. He also identified the distinction between existing scarce cryptocurrencies (e.g., bitcoin) and the promise of future tokens offered by ICOs, and explained that each presents a unique set of risks deserving tailored regulatory consideration. Mr. Valkenburgh said that cryptocurrencies should be treated as commodities and fall within the CFTC’s jurisdiction, while ICO tokens should be treated as securities and regulated by the SEC.

Robert Rosenblum, Partner at Wilson Sonsini Goodrich & Rosati, argued that not enough is yet known about cryptocurrency markets to establish a comprehensive legislative or regulatory framework. In the short term, he suggested that Congress (i) appoint a single federal regulator to have primary jurisdiction over ICOs, tokens and token-related platforms, (ii) authorize the SEC and other regulators to waive certain rules, as applicable to cryptocurrency activity, that may impede blockchain or cryptocurrency development, and (iii) expressly preempt certain state laws that may impose unnecessary requirements on cryptocurrency-related entities and platforms. In the long term, Mr. Rosenblum suggested building a comprehensive legislative framework that is simple, tailored to address the needs of token investors and users, and protects against systemic risk.

IOSCO Issues Recommendations to Protect Senior Investors

The International Organization of Securities Commissions (“IOSCO”) published a report on senior financial fraud. The report provides member states and financial regulators with guidance on protecting vulnerable senior investors.

The IOSCO report concludes that senior investors are more susceptible to fraud as a result of declining cognitive capacity, lack of financial literacy and social isolation, among other factors. The report urges member states to (i) strengthen protective measures focused on seniors, (ii) improve financial service providers’ employee training, and (iii) provide guidance on life planning issues, including arrangements for loss of capacity.

The report also issues recommendations for regulators and encourages the development of:

  • educational programs and resources for senior investors;
  • senior-focused specialists within existing assistance programs;
  • research on risks and issues facing seniors; and
  • guidelines and training programs for employees reviewing transactions conducted with senior investors.

Lofchie Comment: Securities firms would benefit from a common framework as to how to handle dealings with senior investors. On the one hand, firms must recognize that they face material liability in facilitating risky investments by seniors. On the other hand, many seniors are perfectly capable, control a lot of wealth, and have long investment horizons.

At a minimum, this means that firms need to be very cautious as to situations in which they may be deemed to exercise discretion or material influence over account decisions. Conversely, firms cannot refuse to comply with the trading instructions of wealthy clients simply because they are elderly. In negotiating this Scylla and Charybdis, firms will benefit from working jointly, along with regulators and interested organizations, in developing common rules of the road.

SEC Chairman Highlights Pressing Matters Affecting Retail Investors

SEC Chairman Jay Clayton urged the Investor Advisory Committee (the “Committee”) to focus on priorities outlined in the SEC Regulatory Flexibility Act agenda. He warned that the Committee’s deliberations on mandatory arbitration provisions and dual-class share structure may require a disproportionate share of resources, and that other authorities and market participants may take action to address these issues. On dual-class structures, Mr. Clayton asserted that any discussion needs to consider additional related concerns beyond just “disclosure deficiencies and investor confusion.”

Mr. Clayton urged the SEC instead to dedicate its resources to matters that affect retail investors, including:

  • Standards of conduct for investment professionals;
  • Examination of equity and fixed income market structure;
  • Regulation of investment products (including exchange-traded funds);
  • Impact of distributed ledger technology;
  • FinTech developments;
  • Elimination of burdensome or ineffective regulations; and
  • Congressionally mandated rulemaking.

Lofchie Comment: That seems a good “to do” list. The priorities reflect a return by the SEC to its traditional missions (which is all to the good) plus FinTech.

Report from FRB Staff Highlights Risks of Nonbank Mortgage Lending

Staff members of the Board of Governors of the Federal Reserve System (“FRB”) issued a report warning that nonbank mortgage lending has increased within the mortgage market to historically high levels, a potentially dangerous development given the short-term lending that nonbank mortgage lenders rely on and the liquidity pressures that could emerge as a result. According to the report, as of 2016, almost half of all mortgages in the U.S. originated with nonbanks (up from around 20% in 2007). These loans represent 75% of the loan originations sold to Ginnie Mae in 2016, indicating that weaknesses in the sector could lead to taxpayer losses. The authors argued that liquidity issues in the nonbank mortgage sector played a significant role in the financial crisis, and questioned the viability of concentrating so much risk in such a vulnerable sector.

The report further describes:

  • why the funding and operational structure of the nonbank mortgage sector remains a significant channel for systemic liquidity risk in U.S. capital markets;
  • why these risks could lead to dislocations in mortgage markets, especially for minority and low-income borrowers;
  • how liquidity pressures played out during and after the 2007-2008 financial crisis;
  • the appeals that nonbank mortgage industry made to U.S. government for assistance; and
  • the ways nonbanks are still exposed to significant liquidity risks in their funding or mortgage originations and in their servicing portfolios.

As noted, the analysis and conclusions set forth in staff working papers “do not indicate concurrence” by the Board of Governors. The report was authored by You Suk Kim, Steven M. Laufer, Karen Pence, Richard Stanton and Nancy Wallace.

Lofchie Comment: Is this an example of a situation where over-regulation of small banks ended up chasing business away from the regulated sector?  Or was the move from regulated bank lenders to non-regulated lenders inevitable given the costs of regulation at any level?

CFTC Commissioner Calls for Creation of Cryptocurrency SRO

CFTC Commissioner Brian Quintenz advocated for the creation of a self-regulatory organization (“SRO”) focused on the oversight of cryptocurrency platforms.

In remarks delivered at the DC Blockchain Summit, Mr. Quintenz addressed the issue of the proliferation of cryptocurrencies and initial coin offerings. He described various oversight and regulatory challenges including jurisdictional limitations that restrict CFTC authority over spot markets.

Mr. Quintenz advocated for the creation of a private, independent organization aimed at developing standards and policing cryptocurrency platforms. Citing the success of SROs such as FINRA, the NFA and the MSRB, Mr. Quintenz suggested that a similar organization could be established in order to (i) set best practices and industry standards for cryptocurrency platforms and (ii) eventually enforce rules and supervise members for compliance. He pointed to independent bodies that had been established in other countries, and said that creating such an organization could help to “create uniform standards for these trading platforms, reduce the possibility of regulatory arbitrage, and avoid duplicative regulation.”

Mr. Quintenz also highlighted what he sees as several advantages over federal regulators, including that SROs: (i) do not require new legislation in order to quickly establish oversight, (ii) are funded by members as opposed to the federal government, and (iii) have the ability to expediently create or amend rules. He said that the IOSCO Principles for Self-Regulation could be used as a framework to establish a self-regulatory group for cryptocurrency. While SROs must be subject to the oversight of a government regulator, Mr. Quintenz said, an “SRO-like” entity could begin to establish a framework for standard-setting as Congress considers potential federal action.

Lofchie Comment: While there is a growing consensus that there should be a federal system of regulation of cryptocurrencies and ICOs, it seems unlikely that the development of such a system can be accelerated by reliance on a system of “self-regulation.” Such systems succeed because members interact extensively with each other and share a mutual interest in the development of the industry and the product as a whole.

These are not the characteristics of the crypto industry. To a good extent, one may even question whether crypto firms are issuing a common product. Further, Mr. Quintenz may overestimate the degree to which the U.S. self-regulatory organizations are genuinely self-regulatory; in fact, at least on the securities side, SROs are very much under the authority of the SEC, and function less as “self-regulatory” organizations than as extensions of the government.

FRB Vice Chairman Says Regulators Considering Volcker Rule Changes

Board of Governors of the Federal Reserve System (“FRB”) Vice Chairman for Supervision Randal K. Quarles reported that federal regulators are collaborating on a proposal to make “material changes to the Volcker Rule.” Speaking at the Institute of International Bankers Annual Washington Conference, Mr. Quarles asserted that certain Dodd-Frank regulations have caused compliance challenges and imposed unnecessary burdens on foreign banking organizations (“FBOs”).

Mr. Quarles argued that prior to the financial crisis, there was rapid growth of FBOs in the United States and insufficient regulation. He stated that certain post-Dodd-Frank regulatory requirements, particularly regarding the use of intermediate holding companies, had materially improved the quality of U.S. oversight. That said, Mr. Quarles characterized the Volcker Rule as an “example of a complex regulation that is not working well.”

Mr. Quarles said it was now possible to identify areas for improvement of the statute and the regulations. Mr. Quarles is seeking regulatory flexibility with regard to enhanced prudential standards for FBOs. He stressed the importance of tailoring standards to consider a firm’s actual risk profile, and vowed that the FRB will consider exceptions from certain requirements depending on a bank’s particular circumstances. He also committed to exploring solutions to tailor the rule and reduce burdens, particularly for firms that do not engage in proprietary trading and do not have large trading operations. Absent a statutory remedy, Mr. Quarles asserted, regulators will seek to make improvements by clarifying key terminology (such as “market making-related activity,” “proprietary trading” and “covered fund”). He shared that he expects regulators to explore solutions that will make exemptions more accessible for FBOs and foreign funds.

Lofchie Comment: In many respects, the tone of Vice Chair Quarles’ remarks is similar to previous remarks by CFTC Chair Giancarlo. Each has committed to a careful review of what is working and what is not, and to make improvements that are possible, while minimizing the likelihood of divisive political fights that are not worth the effort. That should provide wide latitude, given how much low-hanging fruit there is in improving on the existing Dodd-Frank regulations.

Congressional Republicans File Amicus Brief Supporting President Trump in Fight over CFPB Appointment

Republican members of Congress filed an amicus brief supporting President Donald Trump and Acting Consumer Financial Protection Bureau (“CFPB”) Director Mick Mulvaney in a lawsuit challenging the President’s authority to appoint Mr. Mulvaney as acting head of the CFPB. The lawsuit was filed by CFPB Deputy Director Leandra English.

As previously covered, the dispute arose after former CFPB Director Richard Cordray left the agency and asserted Ms. English’s authority to serve as Acting Director until a permanent replacement was selected and confirmed by the Senate. President Trump then named Mr. Mulvaney as Acting Director, and Ms. English has since pursued legal action to overturn the appointment. Her challenge was rejected by the U.S. District Court for the District of Columbia and is now being heard by the D.C. Circuit Court of Appeals.

In the amicus brief, the Republican Congress members assert that President Trump appointed Mr. Mulvaney in a manner consistent with his authority under the Federal Vacancies Reform Act (“FVRA”). Ms. English argued that a Dodd-Frank provision supersedes the President’s FVRA authority, prohibits his appointment of Mr. Mulvaney, and allows the Deputy Director to serve as Acting Director until a new Director is confirmed by the Senate.

Lofchie Comment: There is, or at least there should be, a distinction between the question of whether Mick Mulvaney is the right person to head the CFPB and the question of whether there is anyone who believes it is good government, or in any way rational, to empower the departing heads of major U.S. government regulatory agencies to name their successors. If Congressional supporters of Ms. English think this is a good way to run a government, perhaps they should introduce legislation to amend the FVRA and so make it general practice. To do so would make plain that Ms. English’s position is nonsense and works only for the most short-term political advantage. Those who support it should be mindful that it will simply be used against them should Democrats win the next Presidential election.