Meaningful Disclosure : regulation

Fixing the Financial Regulatory System: Geithner and Schapiro Ignore the Need for Mutual Fund Reform

Reed Kathrein — Fri, 27 Mar 2009 16:41:00 GMT

I waited for March 26, 2009, in great anticipation that we might see meaningful change in protecting investors. I pray that my retirement years are not stolen from me as they have been from those who we represent - those who trusted Charles Schwab, OppenheimerFunds, MassMutual and Madoff. However, March 26 came and went with little recognition of why and how this happened by those our new President entrusted to help steer these changes.

Both Timothy Geithner (Secretary of Treasury) and Mary L. Schapiro (SEC Chair) testified today on improving our financial regulatory system. Geithner spoke to Barney Frank and his House Committee on Financial Services, and Schapiro spoke to Christopher Dodd's Senate Committee on Banking, Housing and Urban Affairs. Geithner's testimony can be found here, and Schapiro's here.

Before I start in on my criticism, let me say that I understand that both Geithner and Schapiro are long time industry/regulatory insiders. Change comes slow to those who have been part of the system and failed to step forward early. Certainly, it is better to talk about "failures" than to admit that they were asleep at the switch. It is better to talk in the abstract with little criticism that might incite a lynch mob.

Reading both testimonies, I am dumbfounded at how little attention is paid to the mutual fund industry that took investors' money and started pouring it into any asset available regardless of its objectives.

Geithner gives a strong statement recognizing the need for investor protection:

"[W]eaknesses in our consumer and investor protections harm individuals, undermine trust in our financial system, and can contribute to systemic crises that shake the very foundations of our financial system."

Hear hear! Geithner then swiftly moves on to talk about mortgage lending, not investor protection. Try to sort out the following statement:

"Innovation and complexity overwhelmed the checks and balances in the system. Compensation practices rewarded short-term profits over long-term return. We saw huge gains in increased access to credit for large parts of the American economy, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations they did not understand and could not sustain. The huge apparent returns to financial activity attracted fraud on a dramatic scale. Large amounts of leverage and risk were created both within and outside the regulated part of the financial system."

It's almost like the financial services industry wrote his words: "Tim, throw in words that make it look like 'things' caused us to commit fraud, and then put the blame on the 'many Americans with obligations they did not understand...'"

Let's pretend our mess was caused by poor consumers who did not know what they were buying, instead of the greed; greed of financiers who "created" packages of garbage loans, and dumped them on retirees for huge fees, profits and commissions. This slight of hand makes my blood boil.

Geithner completely leaves out the crimes of our mutual fund industry. Instead, he focuses on Money Market Funds that broke the buck. Big deal. This cost the American people a tad of what was lost in mutual funds by companies that sold "conservative," "stable" investments to retirees following the models that touted moving to bonds in your retirement years to preserve capital and earn income. The Reserves money market fund, when all is said and done, lost about three percent. Oppenheimer's Champion Income Fund lost 79 percent. Schwab's Ultra Short Term Bond Fund lost more than 50 percent.

Schapiro jumps on the fraud bandwagon too. She deplores penny stock frauds and insider selling, she touts the SEC's recent (mostly pre-Schapiro) enforcement activity, but she appears oblivious to reality, and the following statement is laughable:

"Our capital requirements go a long way to ensuring that customer funds entrusted with a broker-dealer are safe in the event the broker-dealer gets in financial trouble. Again, our focus is not to insulate broker-dealers from competition and the risks of failure, but to protect investors in the event that failures do occur. We conduct examinations of these firms to assess their compliance with laws and regulations. And when we find violations or deficiencies, we direct that corrective action be taken."

Think Bernie Madoff Investment Service (a broker dealer regulated by the SEC). Ahhhhh! Capital requirements? Protect? Examinations? Compliance? Of course note the disclaimer; "And WHEN we find..."

Schapiro does however have a solution for making sure Madoff's don't occur:

"I expect the staff to recommend that the Commission consider requiring a senior officer from each firm to attest to the sufficiency of the controls they have in place to protect client assets. The list of certifying firms would be publicly available on the SEC's Web site so that investors can check on their own financial intermediary. In addition, the name of any auditor of the firm would be listed, which would provide both investors and regulators with information to then evaluate the auditors."

"As part of this effort, I expect to come to you in the near term with a request for authority to compensate whistleblowers who bring us well-documented evidence of fraudulent activity."

Ok. Let me get this straight...

Madoff would be required to sign a certification - big help.
The auditors name would be public - oh, this helped the Oppenheimer Tremont Rye fund investors who received audit reports from KPMG and Ernst & Young who believe that they are isolated from liability because they can rely on certifications by Madoff's audit or shoeshine man.
The SEC could now pay whistleblowers who present "well documented evidence...because when Madoff's whistleblower Harry Markopolos came to the SEC for free the SEC could not believe that anyone would blow the whistle for free!

As for mutual funds: NADA, Nothing, Zip! Certainly, she recognizes their importance:

"Ultimately, capital comes from investors - people who invest directly in companies; people who invest in financial institutions that lend capital; people who invest in mutual funds and other pooled vehicles that in turn invest in America's businesses; people who buy municipal securities to help fund the operations of state and local governments; and people who look to the capital markets to save, put away money for their kids' education, and prepare for retirement. Markets that attract this capital are critical to America's economic future."

But Schaprio talks only about the past enforcement efforts and current regulations. As for future change, she talks only about money market funds. She apparently does not recognize that current regulations do not work for mutual funds. The Courts have thrown out the private rights of action under the Investment Company Advisory Act, leaving the paltry resources of the SEC to enforce those laws for an industry with more than $9 trillion in assets. The disclosures are impossible to read, and the funds retain near unlimited power to change their focus overnight...if it brings in more profits. The industry is driven by a need to do what it takes to attract capital.

Neither Geithner nor Schapiro seem to recognize these issues, nor care.

Dear, dear. The more things change the more they stay the same.

Balancing Sensible Governance against Failed Principles: Is this the End to the Wild West of Investing?

Peter Borkon — Sat, 15 Nov 2008 00:58:00 GMT

Like the Wild West, hedge funds are a largely unregulated investment vehicle marketed as a tool for reaping large returns for investors willing to accept higher risk. In the current climate of market volatility, it appears that a sheriff is riding into town and the Wild West of investing may soon end.

From 1999 to 2004, hedge fund assets under management grew by more than 260 percent. It is estimated that by the summer of 2007, more than $1.9 trillion was under management at more than 9,000 hedge funds.

Recently, at the Hedge 2008 Conference in London, one prominent hedge fund manager stated, "In a fairly Darwinian manner, many hedge funds will simply disappear." According to hedge fund research, investors removed $43 billion from hedge funds during the month of September and losses for the past three months top $210 billion.

The question moving forward is, "Who will the sheriff be and when will the sheriff arrive?" As we see it, there are three possibilities.

Public Pensions and Retirement Funds

Driven to maintain or exceed a higher return rate for their retirement systems, many public pensions have decided to invest in this high-stakes corner of the investment world.

United States public pensions are uniquely poised to change how these investments are regulated including advocating for transparency from hedge funds and pursuing recovery for investors.

By early 2007, United States public pension funds had invested $24 billion in hedge funds.

The dilemma is clean, in a climate nearly devoid of oversight, hedge funds do not report trading positions or holdings. They are not required to report how much they owe or to whom they owe. Such strategies are typically at odds with the transparency requirements for pensions.

The Securities and Exchange Commission

Regulation of hedge funds has been a recurring battle and one the SEC has lost on numerous occasions.

In 2006, the Securities and Exchange Commission passed the Hedge Fund Rule that required hedge funds managing more than $25 million to register with the SEC, provide details about operations and submit to periodic audits.

The SEC's attempt to impose regulation was as short lived as the sheriff riding into early Tombstone. The Hedge Fund Rule became effective on Feb. 1, 2006, and by June of 2006, the Court of Appeals for the D.C. Circuit shot the rule off its horse.

On Sept. 17, 2008, SEC Chairman Cox asked the commission to consider an emergency disclosure rule requiring hedge funds and other large investors to disclose their short positions. Managers with more than $100 million invested in securities would be required to begin publicly reporting their daily short positions.

The SEC's proposed rule was altered when the SEC changed course because hedge fund managers complained that requiring public disclosure would put them out of business because other investors could copy their investing strategies. In response, the new SEC rule only requires hedge fund managers to report their short positions to the SEC on a weekly basis and not to the investing public.

On Oct. 15, 2008, the SEC extended the rule to Aug. 1, 2009.

Additional SEC efforts to regulate are likely to emerge in the short term. Turning to the last option, legislators are faced with the burden of fixing a broken market.

Legislators

So, what reforms may be riding into town?

We know that hedge funds are fiercely protective of their investment strategies and that they are girding themselves for a fight over disclosure and regulation. It is clear that this industry is currently under the microscope and there is strong backing from political leaders throughout the country to regulate hedge funds.

There are three schools of thought emerging in Washington:

Analysts are floating ideas about disclosing investments 45 days after the close of a quarter to allow for a cooling period - making any disclosures historic;

Full disclosure to the SEC is necessary but can be confidential; or
Total transparency to the market - meaning full disclosure to all.
Regardless of the source or solution, reform will take time.

Before reform is agreed upon and in place, the leading edge may come through private litigation. Numerous hedge funds are being sued by investors, including public pensions, for various causes of action including breach of fiduciary duty, gross mismanagement, breach of contract, fraud, negligence, and violations of federal and state securities laws.

As Ann Yerger, executive director of the Council of Institutional Investors recently stated, "Now is not the time to yield to pressure from Wall Street lobbyists to further shelter financial firms."

Indeed, now is the time to guide hedge fund reform and to create sensible reforms in the face of failed principles.

You can contact me and view my LinkedIn profile here.