Cynthia Formelli of the Securities and Exchange Commission talks to Dylan Emery about the changes they are making in order to keep pace with the financial services market
The Securities and Exchange Commission (SEC), the hard-hitting US regulator, has been forced into a series of important changes in response to a rapidly changing financial services market.
Cynthia Formelli, deputy director, division of investment management at the SEC, explains that through changing times, the fundamental approach of the SEC has always been to focus on the consumer.
She says: 'We view the protection of investors as our first and foremost priority. We are here to make sure investments that are offered are accompanied by full and fair disclosure, so it's very much a disclosure regime.
'Of course that is not entirely true ' many of our regulations have an element of paternalism to them to make sure there are some requirements and restrictions to them, but generally it's a disclosure regime.
'And we find ourselves at a crossroads. It's been a very interesting time over the last year. The terrorist attacks in the US was an extraordinary event for the financial markets in the US. We are quite proud of how the markets recovered: there was a seamless reopening of the market; they were only closed for a few days and there was little disruption.'
Formelli attributes the fast recovery time to the systems put in place by both fund management companies and the various services providers they use in the run up to the year 2000. Then there were widespread fears that computer failures could undermine the smooth running of both the companies involved and the markets themselves. As such, a great deal of time and money was spent updating systems and making them more robust. The preparation paid off, even if it was in entirely different and unexpected circumstances.
She continues: 'Of course, soon after that, we had the whole Enron debacle, which again tested the securities markets and the regulation of those markets. Accompanied by that are the accounting scandals that threaten to continue to be revealed. I think it's fair to say we've seen some revolutionary times in the industry.
'The chairman of the SEC has said on many occasions we are investigating all our laws, not just in the investment management area but across the board. Nothing is off the table. I think there are some things he wanted to do regardless, given the global nature of the economy and all the technology advances that have sprung up over the years.
'So we are the start of revolution and you will see major changes.'
disclosures and overhauls
One of the proposed changes is to shorten the amount of time a public company has to make disclosures for special events. It used to be five to 15 days. This will be reduced to two.
The accounting industry is also looking at a substantial regulatory overhaul. There is a proposal to set up a new public accounting board to oversee the accounting industry. This body would have the ability to fine and censure accountants and accounting firms. The body would not have subpoena powers at the start, but that is something the SEC is looking at, according to Formelli.
Unsurprisingly, there is quite a heated debate about who gets to sit on the board. The accounting industry very much wants to see accountants on that board but there will be people from the public sector involved as well.
There will also be a look at the time taken to force companies who have strayed to change their ways. At the moment, enforcement is largely retroactive.
'In the past sometimes enforcement has taken years to come about ' long after the wrongful activity had occurred and long after the damage had been done to investors,' says Formelli. 'The real push now is to get these cases brought quickly before the harm is done and before the money is gone.'
Another by-product of the Enron and WorldCom affairs has been to focus a spotlight on corporate governance and the responsibilities of senior management.
There is a proposal to make CEOs and CFOs of public companies certify their publicly disclosed documents including their financial statements to ensure their 'veracity, accuracy and fairness.'
'You can imagine this is quite a big step for a CEO or CFO to do ' to have to put their name to their accounts,' says Formelli. 'But if you're the person responsible for the company you should be able to stand by those documents. There would also be a liability attached to that too, and of course that's the point.
'If within a company you have supervisory schemes in place we are looking for ways to make those people responsible. Previously, there was a requirement that 40% of the board of directors be independent, our new rules require that the majority of directors be independent.'
Concerning the mutual fund industry specifically, there will be new regulation concerning performance disclosure, including showing the impact tax will have on fund performance for investors. The SEC has also adopted a new names rule, so if the fund has a descriptive name, 85% of assets of the fund must be held in that asset class.
The advertising rules are to be revamped and there will be more performance disclosure by the fund than now. The proposals require funds to mention websites, phone numbers, or newspapers where investors can get more real-time disclosure.
The SEC is also looking at requiring funds to disclose the holdings of their portfolios more frequently than they do now, which is twice a year.
Causing a stir
Formelli continues: 'Another area that caused quite a bit of a stir in the mutual fund industry and the hedge fund industry was that at the end of May, the chairman's speech noted the commission will be conducting a formal inquiry into hedge funds.'
The particulars have not been made public, but the goal will be to look at three main areas. First, the perceived increase in hedge fund fraud ' and Formelli says there has been an increase in fraud in the hedge fund area in the past five years. Of course there is also an increase in assets in hedge funds, so it has yet to be seen whether that fraud increase is proportional or disproportional to that.
Second, Formelli continues: 'We will also look at the potential conflict of interest that can arise when a portfolio manager manages both a registered fund and an unregistered fund. There are some issues with allocation. Hedge funds have a much more liberal compensation structure and they contain performance fees, and so there could be an incentive to put the better trades, particularly the higher geared trades, into the hedge funds as opposed to the mutual fund. That may be valid if the mutual fund doesn't have those kinds of objectives, but those are the kinds of conflicts of interest we want to see managed properly.'
Third, there are the problems associated with sales by hedge funds to retail investors. Under the regulatory scheme now, hedge funds don't have to register with the SEC if they sell their securities to qualified purchasers, with a net asset of $5m or if they sell to accredited investors in their fund ' someone who has $250,000 invested in their fund or a net asset value of $1m. The thought behind these policies (which are congressional mandates, not SEC rules) is that sophisticated investors don't need the protection the way that other, less sophisticated investors will.
'But one might ask if the accredited investor test is truly a test in today's environment,' says Formelli.
This worry derives from the effects of house price inflation and general inflation, which has pushed a large number of unsophisticated investors into these exclusive net worth bands.
A number of managers are considering having a registered fund of funds scheme, at least some of which will be invested in hedge funds. The SEC will be examining these schemes and asking how transparent they can be, if their constituent funds are not particularly forthcoming.
'It raises issues of valuation,' explains Formelli. 'Will the fund of funds have enough information about the hedge fund to do their daily valuation they are required to do and will the fund be able to explain those valuations properly to investors?'
The commission looked at hedge funds after the near-collapse of long-term capital management, but that focused much more on market structure, counter-party issues and systemic risk rather than investor protection issues.
She adds: 'I suspect we'll be talking to all participants in the hedge fund industry and you'll be hearing a lot more about that.'
There is a proposal to make CEOs and CFOs of public companies certify their publicly disclosed documents including their financial statements to ensure their ˜veracity, accuracy and fairness.'
Advertising rules are to be revamped and there will be more performance disclosure by funds than now.
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From 6 April 2019
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