SEC Investor Advisory Committee Meeting
Opening Remarks
Commissioner Hester Peirce
In her welcome remarks, Peirce remarked that the discussion about unpaid arbitration reflects the fact that the industry, financial regulators, and investors are all trying to solve the problem. Regarding environmental, social and governance (ESG) investing, Peirce noted that it is important to remember that ESG means a lot of things, including that shareholder money is being spent on things that are not actually beneficial to shareholders.
Commissioner Kara Stein
In her welcome remarks, Stein said that ESG factors cover a wide range of issues, including carbon emissions, labor, and human rights, and while these factors have historically not been considered as part of financial analysis, many investors have become increasingly interested in them when considering the long-term investing risks and benefits associated with ESG matters. Stein added that some investors believe there are verifiable links between ESG matters and a company’s operational and management strength, while other investors believe focusing on ESG should not come at the expense of investment returns. Stein said it is important to find the right balance and explore whether reporting standards would help, and if so, what those standards should look like. Regarding unpaid arbitration awards, Stein noted that although the dollar amount of unpaid arbitration awards has been trending down, there is “a ways to go,” saying that the process is vital to both investors that have been harmed and broker-dealers that are playing by the rules.
Chairman Jay Clayton
In his welcome remarks, Clayton said the ESG issues and unpaid arbitration are issues he has been considering in ensuring the SEC carries out its mission. Clayton said that disclosure is at the heart of the SEC’s approach, and the mix of information that companies provide to investors must facilitate sound decision making. Clayton noted that ESG is a very broad term, and the focus regarding disclosures should be on material disclosure that meets reasonable investor needs. Clayton added that investors and asset managers that are required to vote and make purchase and sale decisions in the best interest of their clients should focus on each company’s particular facts and circumstances. Clayton said it is important to note that while the SEC regulates investment advisors, it does not regulate the merits of any particular investment strategy, but it is important investors have full and fair disclosures about what strategy their investment advisor is following.
Regarding unpaid arbitration awards, Clayton highlighted the potential impact unpaid arbitration can have on main street investors. Clayton noted the SEC’s focus on protecting main street investors, including their work on Regulation Best Interest, the development of resources to educate retail investors, and their retail strategy task force which works to protect retail investors. Clayton said that while the enforcement division has returned millions to retail investors, they often measure success in terms of the amount of money returned but should also focus on how soon that money is returned to investors that have been harmed.
Q&A with SEC Chairman Jay Clayton
Reporting Framework
Anne Simpson, Investment Director, Sustainability, California Public Employees’ Retirement System, asked what type of 21st century reporting framework is needed, to which Clayton replied that the Commission has to assess whether disclosure rules from decades ago have kept up with the global economy. He continued that he believes disclosure based on materiality, responsibility and comparability is still the right framework and does not need to be changed, but what goes into the framework may need to be assessed.
Disclosure Requirements
Allison Bennington, Partner and Chief Global Affairs Officer, ValueAct Capital, discussed how the time is right to update disclosure requirements and what modern disclosure documents may look like. Clayton said he “couldn’t agree more,” and that aside from 8-k disclosure reports, for the most part earnings press releases and earnings calls are the “topics that matter.” He continued that what investors care about can be found in a “much shorter document” and that the SEC needs to look at ways to streamline based on empirical evidence. Stein added that the SEC should continuously have this discussion and questioned how to update and “get it right.”
Markets in Financial Instruments Directive (MiFID) II
Stephen Holmes, General Partner Emeritus, InterWest Partners, asked about the impact of MiFID II, to which Clayton replied that he has encouraged the Investor Advisory Committee to have research and the availability of research on their agenda, and noted his concern that the availability of research will shrink due to MiFID II. It was noted that this topic is on the Market Structure Subcommittee’s agenda.
Modernizing EDGAR
Susan Ferris Wyderko, President and CEO, Mutual Fund Directors Forum, asked about modernizing EDGAR, to which Clayton replied that it would require a multi-year project, which creates limitations since the Commission is funded year-to-year, but that they are taking an incremental approach to modernizing.
Accredited Investor
Barbara Roper, Director of Investor Protection, Consumer Federation of America, discussed the private placement market and the qualifications to be an accredited investor, noting that the Investment Advisory Council has had arguments about raising or not raising thresholds and how a binary approach “isn’t logical.” Clayton replied that the current patchwork system has “room for improvement” and that he is “not in love” with the accredited investor system due to it being binary. He added that while it is a “difficult nut to crack” it warrants exploration.
Discussion Regarding Disclosures on Sustainability and Environmental, Social, and Governance (ESG) Topics
Panelists discussed the current landscape in ESG disclosures and some paths to move forward as investor interest in such information increases. Daniel L. Goelzer, Senior Counsel/Retired Partner, Baker & McKenzie LLP, noted that the SEC has not developed specific disclosure requirements for ESG matters, and the current approach to sustainability reporting was developed in the 1970s. He said disclosures must have information that is necessary to inform investors’ investment decisions, focused on the economic interests of investors. He noted that many companies already make voluntary ESG disclosures outside of SEC filings, but often these reports are not designed to be comparable to those of other companies, even within the same industry, saying there would be benefits from consistency and comparability in the reporting of sustainability information.
Janine Guillot, Director of Capital Markets Policy and Outreach, Sustainability Accounting Standards Board (SASB), gave an overview of the work of the SASB and their accountability standards. Guillot noted that their goal is to enhance the quality of sustainability disclosure and communication to shareholders. This includes identifying sustainability topics most likely to impact financial performance in a particular industry and to develop standardized industry-specific performance metrics. She added that it is ultimately up to individual companies to decide what is financially relevant to them, and as sustainability disclosures rapidly evolve, there may be a role for the SEC to be involved.
Curtis D. Ravenel, Chairman’s Office, Global Head, Sustainable Business & Finance, Bloomberg LP, said that as investors started to demand more ESG information, Bloomberg LP began to look deeper into the data, finding a “highly incomplete” ESG data set. He contributed this to “cherry picking,” noting that when reporting this data is voluntary, companies will report the metrics that make them look best, rather than a complete picture. Ravenel noted that the SASB approach makes sense, as it de-politicizes an issue that has become “politically polluted,” adding that there is sustainability data that makes sense for investors no matter what political side they are on. Ravenel noted that climate risk could have implications for all industries, and ESG information can help markets avoid climate-related asset risk. He said that some companies want to disclose, but thus far have not had a framework to do so effectively, and to evaluate if climate risks are financially material to their strategy.
Jennifer Bender, Senior Managing Director and Director of Research for the Global Equity Beta Solutions Team, State Street Global Advisors, noted there has been an “explosion” of research in this area recently, though highly subjective, and that asset managers have an “acute” interest in the rise of ESG issues as “caretakers” of long-term capital. Bender said there are significant data challenges when looking at ESG matters because companies have not been historically required to report on them, and there are no standards for reporting, but ESG data has proliferated despite this. Bender added that there are more than 125 ESG data providers reporting on this information and providing ratings, and some have developed ways to normalize, aggregate, and weight metrics, but the lack of standardization has presented challenges for investment managers. Bender indicated her support for SASB’s initiatives, saying it is important to focus on financial materiality and long-term shareholder value. She said a standardized reporting framework is essential, and without it the field is highly subjective and affected by unknown biases.
Yafit Cohn, Associate Group General Counsel, The Travelers Companies, Inc., said that requests for ESG information without standardized reporting has resulted in a drain on corporate resources, time, and attention, and companies are facing increasing pressure from groups with various interests, goals, and views, “exacerbated” by the incorporation of ESG issues into proxy voting reports. She said companies are struggling to make informed decisions about what issues matter to their investors and which do not, highlighting that there is confusion across industries about the definition of ESG, with many conflating ESG with impact investing, corporate social responsibility, and other social impact issues. Cohn said there should be enhanced disclosure, as proactive disclosure allows companies to focus investor attention on the issues most relevant to their businesses. She said it is “crucial” the SEC continues to review financial materiality, ensuring it serves issuers and investors well in this space.
Jill E. Fisch, Saul A. Fox Distinguished Professor of Business Law and Co-Director, The Institute for Law and Economics, University of Pennsylvania Law School, said the SEC is important for its role in setting norms, expectation, standards of materiality, and standards for the overall market. She said investors are telling companies to manage their operations with ESG issues in mind, and those companies are listening. Fisch said that in the ESG space, there is need for the quality of disclosure that currently exists for financial disclosures, and SEC action is a “critical” first step. Fisch explained that an SEC mandate would heighten what SEC disclosure rules have always done – give guidance to companies about the governance framework that should be reflected in their reporting. She said an SEC mandate would also provide comparability, as well as bring control over disclosures into the hands of securities and disclosure lawyers and SEC staff, who are experts in reviewing, providing guidance, and setting norms across an industry.
Discussion Regarding Unpaid Arbitration Awards
Christine Lazaro, President, Public Investors Arbitration Bar Association; Professor of Clinical Legal Education and Director of the Securities Arbitration Clinic, St. John’s University School of Law, argued that investor protection should be more than making arbitration available to them, as it does not help them recover costs, as many times investors go through the arbitration process and are given arbitration awards that are never paid. She discussed examples of ways FINRA could solve this problem: 1) Impose an industry-wide insurance requirement for unpaid awards (recognizing that fraud and other claims likely would not be paid under such policies); and 2) Create a national recovery pool administered by FINRA that would be funded by enforcement fines from firms that engaged in misconduct, and/or through a member surcharge, assessing values based on a firm’s overall risk (with higher risk members paying larger fees). Lazaro commented on industry concern that the payment of an award from those not responsible could create moral hazards, noting that the broker or firm should not be “let off the hook” for misconduct, and that FINRA should continue to condition firm membership on the full payment of awards.
Richard W. Berry, Executive Vice President and Director of Dispute Resolution, FINRA, talked about the discussion paper on customer recovery that FINRA released earlier this year and how FINRA met with stakeholders to better understand various concerns and perspectives. He then discussed how FINRA rules do not require broker-dealers or customers to enter into arbitration agreements and how FINRA’s role in the arbitration process is only to administer. Regarding FINRA arbitration forums, he noted that the SEC oversees the forum and approves rules, with investors being charged low arbitration fees and having the option of having a panel with no ties to the securities industry, as well as limitations on the ability to dismiss cases. Berry explained that most arbitration cases are resolved without the need for an award, but of those cases warranting one, only about two percent of them go unpaid. He continued that FINRA has been more transparent about a broker’s arbitration history, providing data on unpaid customer awards for the past five years on their website, as well as those who are responsible for the unpaid awards. Berry then discussed the proposed options to address unpaid awards, to include a rulemaking by the SEC to require firms to raise or maintain additional capital, amendments to Form BD to require disclosures regarding a firm’s unpaid awards, legislation to amend the Bankruptcy Code so arbitration awards are not discharged during bankruptcy, legislation to expand Securities Investor Protection Corporation (SIPC) coverage, and legislation to require brokerage firms to have insurance to cover unpaid awards, adding that they are “all worth exploring further.”
Robin Traxler, Senior Vice President, Policy & Deputy General Counsel, Financial Services Institute, discussed three of the suggested approaches, noting that each of them will have unintended consequences: 1) S. 2499, Sen. Elizabeth Warren’s (D-Mass.) legislation that would require FINRA to establish a relief fund to provide investors with the full value of unpaid arbitration awards issued against brokerage firms or brokers regulated by the Authority; 2) mandated insurance coverage; and 3) increased net capital requirements. Regarding Warren’s bill, she explained that it will not allow FINRA to limit the amount paid to an investor, and that while it is well-intended, the fund may encourage bad actors to be reckless, could encourage arbitration panelists to award damages to investors whether or not they are justified, and that the drawbacks “far outweigh the good.” Traxler then explained that mandating insurance coverage would be expensive, especially for small firms and independent financial advisors, and that it is “unlikely to solve the issue.” Lastly, she discussed increasing the net capital requirements for small firms that only have a $5k net capital requirement to $200k, which is “not a viable solution” as smaller firms will not be able to afford it.
Jill Gross, Associate Dean for Academic Affairs and Professor of Law, Elisabeth Haub School of Law at Pace University, gave a history of the arbitration process and explained how there are characteristics unique to the securities industry that “exacerbate” the problem of unpaid arbitration awards. She noted that arbitration panels in other industries allow the naming of all entities thought responsible as defendants, such as parent companies, but that it is not done in FINRA arbitration and instead parent companies are “insulate[d]” from liability. Gross proposed the idea of a fund like the legal profession has, where many states have annual fees for lawyers that go into a fund for client protection that collectively shares the liabilities if a lawyer cannot pay. Lastly, she explained that the success of a dispute resolution forum will depend on how it is perceived by the public, as an unfair perception will lead to a lack of respect and faith in the arbitration system.
Q&A
John Coates asked about creating a backup to FINRA removing bad actors from the industry by way of an industry-based self-assessment program that would create an insurance pool to be used when awards are not paid. Traxler replied with her concern that a pool of money will encourage bad behavior and recommended having parameters around payouts, or possibly other types of funds that could pay for the awards.
In response to a question from Roper on how to determine how much each firm would have to contribute to the insurance pool, Lazaro replied that the fund amount could be based on a trailing 5-year average of unpaid awards on a per broker basis, estimating around $50-60 per broker. She continued that this method will require larger firms to pay more than the smaller firms where much of the misconduct may be going on, so it makes more sense to not do a flat fee per broker charge.
Damon Silver asked the speakers to discuss the effectiveness of Warren’s S. 2499 versus restructuring the industry so liabilities flow upward. Lazaro replied that the benefit of a pool is that the money is there when claims come in and easier to create and accomplish than restructuring the industry. Berry explained that regarding regulatory arbitrage, if changes are only made for brokerage firms and not investor advisors there could be a movement away from the broker-deal model due to the heavy regulation they are subject to. Gross voiced her preference for a fund over legislation because legislation can change with different political parties in charge.
In response to a question from Coates about choosing between a fine-funded pool (like Warren’s S.2499) or creating a new fund based on projected risk-assessed premiums based on a 5-year history, Berry replied that the latter choice “makes more sense.”
Roper asked about issues of concern with SIPC expansion or the creation of a FINRA fund, to which Lazaro replied that both options make sense because they rely heavily on the bad actor doing the bad acts, but that she prefers a FINRA-administered pool because FINRA knows whether an award is paid. She added with her belief that it would be easier to create a new fund than try to repurpose SIPC.
Berry noted that FINRA has made suggestions to change arbitration rules, to include proposals outstanding to change membership application rules and Discovery Guide expansion to cover insurance information. He continued that Regulatory Notice 18-15 was a guidance to firms on implementing heightened supervision for people with past misconduct, and that Regulatory Notice 18-16 was a solicitation for comments on the proposal to target high-risk brokers and their firms.
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