SBC Hearing with SEC Chairman Clayton

Senate Banking Committee

“Oversight of the U.S. Securities and Exchange Commission (SEC)”

Tuesday, December 11, 2018

Key Topics & Takeaways

• US/EU Regulatory Equivalence: Sen. Mike Rounds (R-S.D.) discussed the 2016 agreement between the U.S. and EU that the CFTC regime was equivalent for U.S. companies doing business in the EU but noted that there is not one for the SEC’s regime. Rounds added that if pending legislation in the European Parliament passes, large American clearing firms may only be able to do business in the EU if the EU regulators can jointly regulate them, which would violate the 2016 equivalency agreement. He asked for Clayton’s thoughts on this issue, as well as any other regulatory challenges Brexit may present. Clayton replied that it is a “complicated issue” that will have costs if a smooth path forward cannot be identified, adding that there are issues with Brexit that “get kicked down the road as it unfolds.”
• Regulation Best Interest: Clayton explained that the “baseline” investment advisor standard is that the advisor cannot put their interests ahead of those of their client, but can “cut back” with informed consent, and the standard for a broker-dealer will be a “fundamental duty” to not put their own interests ahead of their client. Asked if broker-dealers can create sales incentives under the proposed rules, Clayton explained that some incentives would be allowed, but others are “inconsistent” with the principle of putting the best interest of the client first.
• Consolidated Audit Trail (CAT): Sen. Jerry Moran (R-Kan.) noted that CAT will contain sensitive trade data that will be a “major target” for cyber criminals. He continued that broker-dealers have to report PII to CAT and rely on the security measures of CAT, and asked Clayton what the SEC is doing to require CAT operators to provide prompt notification of a data breach, and that broker-dealers will not be held liable for such breaches. Clayton replied that the SEC is focusing on these issues, as well as whether retail customer PII will not go into the CAT. He would not comment on the liability question but noted the SEC is “sensitive to those issues.”

Witness

• The Honorable Jay Clayton, Chairman, SEC

Opening Statements

Sen. Mike Crapo (R-Idaho), Chairman

In his opening statement, Crapo said the work of the Securities and Exchange Commission (SEC) to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation is “critical,” and commended their work to provide information so investors can make informed decisions. Crapo noted that the Committee recently held a hearing on the proxy voting process and expressed his concern about the “misuse” of proxy voting to prioritize environmental, social, and political issues over the economic interests of investors, encouraging Clayton to take an “aggressive” approach in addressing proxy rules that have not been examined in decades. Crapo acknowledged the SEC’s proposed Regulation Best Interest, calling it a “significant step forward,” and said he looks forward to seeing the final rule.

Sen. Sherrod Brown (D-Ohio), Ranking Member

In his opening statement, Brown discussed the SEC’s enforcement program, acknowledging that the SEC has worked hard to return money to harmed investors. He noted that while the SEC continues to find and punish Ponzi schemes and other wrongdoers, they must also pursue complex cases against large financial institutions when they “break the rules.” Brown critiqued the SEC’s strategic plan, particularly that it does not address stock buybacks or excessive corporate debt, calling it a “risk to workers and communities” when companies think only about their short-term profits. Brown encouraged the SEC to “worry about what no one else is worrying about” so risks do not build up across the system, and to complement the work of banking regulators as the financial system is “more interconnected than ever.”

Testimony

The Honorable Jay Clayton, Chairman, SEC

In his testimony, Clayton focused on the key emerging market risks the SEC is identifying, evaluating, and addressing. He noted that cybersecurity is still a “pressing” threat to the capital markets and its participants, and that the SEC requires additional funding to continue to combat challenges that could cause systemic risk. Regarding Brexit, Clayton explained that the potential impact is not yet well understood and is possibly being underestimated and added that the SEC is focusing on disclosures companies can make on Brexit and how market utilities and infrastructure will function. He then discussed the movement from the London Inter-Bank Offered Rate (LIBOR) to the Secured Overnight Financing Rate (SOFR) and how it is a “significant” issue for Main Street investors who have credit tied to LIBOR, noting that the financial regulators are monitoring the issue and are working together to facilitate a “reasonable transition.” Finally, Clayton discussed the development and implementation of the Consolidated Audit Trail (CAT), stating that it is “significantly behind deadlines” and how the first phase will not be implemented until 16 months after its initial deadline. He stressed the importance of personally identifiable information (PII) and how the SEC, self-regulatory organizations (SROs) and plan processors will continue to have to work to protect PII, adding that the SEC will not retrieve any sensitive data from CAT unless it is “absolutely necessary.”

Question & Answer

Proxy Voting

Sens. Crapo and Pat Toomey (R-Pa.) asked about proxy voting, to which Clayton replied that there are three issues within proxy voting: 1) proxy “plumbing,” noting that the verification process does not “work as well as it should;” 2) shareholder voting; and 3) proxy advisors, noting the “broad agreement” that parts of the proxy advisory ecosystem can be improved “fairly quickly” and that the SEC will continue to look at the regulation of proxy advisors.

Leveraged Lending

Brown noted his concern with leveraged lending asked what the SEC is doing to monitor the growth of such loans outside of the traditional banking system, to which Clayton replied that they are looking at all of the components in these deals and whether there are elements that could cause systemic risk. He continued that he has already brought analyses of this to the members of the Financial Stability Oversight Council (FSOC).

Public Companies

Toomey noted that Clayton has acknowledged that the regulatory costs of companies being public may contribute to the decline in the number of companies going public in the U.S., to which Clayton agreed that the regulatory costs may be a factor.

Stock Buybacks

Sens. Jack Reed (D-R.I.) and Chris Van Hollen (D-Md.) asked what steps the SEC can take to correct the current trend of corporate stock buybacks. Clayton explained that the SEC has little authority in this area and cannot dictate whether a company distributes its capital to shareholders. Clayton said it is important to look at how companies communicate with their shareholders about what they intend to do with their capital, and there is room for improvement in disclosure. Clayton noted there is no safe harbor if buybacks are carried out with the intent to manipulate stocks.

US/EU Regulatory Equivalence

Sen. Mike Rounds (R-S.D.) discussed the 2016 agreement between the U.S. and EU that the CFTC regime was equivalent for U.S. companies doing business in the EU but noted that there is not one for the SEC’s regime. Rounds added that if pending legislation in the European Parliament passes, large American clearing firms may only be able to do business in the EU if the EU regulators can jointly regulate them, which would violate the 2016 equivalency agreement. He asked for Clayton’s thoughts on this issue, as well as any other regulatory challenges Brexit may present. Clayton replied that it is a “complicated issue” that will have costs if a smooth path forward cannot be identified, adding that there are issues with Brexit that “get kicked down the road as it unfolds.”

Incentive Compensation

Sen. Bob Menendez (D-N.J.) asked if pay practices at large financial institutions “reward risky behavior,” to which Clayton said that certain incentives can drive behaviors but declined to make any broad statements about incentive compensation. Clayton added that investors should have clear disclosures about the compensation of senior leadership at the companies they invest in, and that there should be accountability. Asked why reigning in pay practices as mandated in Dodd-Frank has not been a priority, Clayton said the SEC has proposed rules on some issues and the hedging rule is on the near-term agenda.

Municipal Securities Rulemaking Board

Sen. John Kennedy (R-La.) asked about the Municipal Securities Rulemaking Board (MSRB) rules that allow states to file their financial information up to a year after the end of their fiscal year. Clayton called it an “area for improvement,” saying they need to make sure investors understand the financial statements they are looking at are, in some cases, up to 18 months old.

Regulation Best Interest

Sen. Elizabeth Warren (D-Mass.) asked about the SEC’s proposed Regulation Best Interest and why broker-dealers and investment advisors are subject to different standards, as well as whether the rule clearly defines what a “best interest standard” is. Clayton replied that the SEC is “pretty clear,” explaining that the “baseline” advisor standard is that the advisor cannot put their interests ahead of those of their client, but can “cut back” with informed consent, and the standard for a broker-dealer will be a “fundamental duty” to not put their own interests ahead of their client. When Warren asked why the SEC does not use the same words for both, Clayton replied “we may do that.”

Sen. Catherine Cortez Masto (D-Nev.) asked if broker-dealers can create sales incentives under the proposed rules. Clayton explained that some incentives would be allowed, such as growing assets under management, but other incentive activities are “inconsistent” with the principle of putting the best interest of the client first.

Consolidated Audit Trail (CAT)

Sen. Jerry Moran (R-Kan.) noted that CAT will contain sensitive trade data that will be a “major target” for cyber criminals. He continued that broker-dealers have to report PII to CAT and rely on the security measures of CAT, and asked Clayton what the SEC is doing to require CAT operators to provide prompt notification of a data breach, and that broker-dealers will not be held liable for such breaches. Clayton replied that the SEC is focusing on these issues, as well as whether retail customer PII will not go into the CAT. He would not comment on the liability question but noted the SEC is “sensitive to those issues.”

Gag Rule Settlements

When asked by Sen. Tom Cotton (R-Ark.) what public interest the SEC’s gag rule serves, noting that the Commission should “probably reconsider it,” Clayton replied that the gag rule is “an effective means to reach settlement” and allows matters to be settled quickly. He added that the gag rule is “not the right approach in every matter.”

For more information about this hearing, click here.