In my paper, Taxing Unreasonable Compensation: §162(a)(1) and Managerial Power, which is forthcoming in the Yale Law Journal, I argue that IRS should disallow tax deductions for unreasonable compensation paid by publicly held corporations.

Section 162(a)(1) of the Internal Revenue Code allows companies to deduct “a reasonable allowance for salaries or other compensation.” The IRS has systematically interpreted “reasonable allowance” to apply only to closely held corporations, effectively concluding any amount of compensation paid by a publicly held corporation is “reasonable.” The IRS bases this interpretation on the presumed arms-length nature of the board-CEO relationship, which sets compensation at a “reasonable” level.

I argue that, in light of the managerial power hypothesis, executives may exercise undue influence over the board in setting their compensation. Therefore, publicly traded corporations may lack the appropriate oversight and incentive infrastructure to set executive compensation reasonably. Thus, the IRS should examine the compensation of both publicly and privately held corporations.

I suggest two methods for achieving this result: first, the IRS could employ the same multi-factor test to evaluate compensation paid by publicly traded corporations as it does for the compensation paid by their privately traded brethren. Second, the IRS could assess the objective traits of the corporations CEO-board relationship to determine the propensity for management influence in the setting executive compensation.

The full paper is available for download here.

On Jan. 1, 2009, Merrill Lynch & Co. Inc. (”Merrill”) merged with Bank of America Corporation (”BofA”). [1] At the end of 2008, prior to the close of the merger, Merrill awarded approximately $3.6 billion in bonuses to its employees. The payment of these bonuses has been the subject of numerous investigations and lawsuits. This column discusses (i) the background to the payment of these bonuses and (ii) a pending lawsuit charging BofA with not furnishing adequate information to its shareholders in connection with their vote on Dec. 5, 2008, in which they approved the merger. [2]

Background

In the one-week period beginning Sept. 13 and ending Sept. 19, 2008, crises erupted at a number of major financial firms. The investment firm of Lehman Brothers filed for bankruptcy. The insurance conglomerate AIG received a pre-TARP bailout of $85 billion (giving the Federal Reserve a 79.9 percent stockholder position; additional amounts subsequently were provided with the total bailout amounting to approximately $170 billion). A third firm facing a financial crisis was Merrill. [3]

On Saturday, Sept. 13, 2008, Kenneth Lewis, the chief executive officer of BofA, met with John Thain, the chief executive officer of Merrill. They discussed the possible acquisition by BofA of Merrill. Merrill’s losses were turning out to be significantly greater than anticipated earlier in the year. Merrill’s losses, the deepening crisis on Wall Street and the precipitous drop in Merrill’s stock price threatened its survival.

On Sept. 15, 2008, BofA and Merrill entered into an agreement to merge (the “Merger Agreement”), subject to shareholder approval which took place on Dec. 5, 2008. Events that took place during this period and that related to year-end bonuses at Merrill included:

• 1. BofA agreed that Merrill could pay up to a $5.8 billion cap in bonuses for 2008 pursuant to the Merrill Variable Incentive Compensation Plan (VICP). This provision was included in a schedule to the Merger Agreement, but that disclosure schedule was excluded from materials distributed with the proxy statement to shareholders. It is understood that exclusion of such a disclosure schedule from materials distributed to shareholders in connection with a vote on a merger or acquisition is customary practice and was accepted by the SEC in BofA’s case.
• 2. The proxy statement summarizes actions that, subject to exceptions there noted, were not to be taken by Merrill. One such action was the payment of bonuses:
  

  [Merrill] further agreed that, with certain exceptions or except with [BofA's] prior written consent (which consent will not be unreasonably withheld or delayed with respect to certain of the actions described below), [Merrill] will not…among other things, undertake the following extraordinary actions…

  • except as required under applicable law or the terms of any [Merrill] benefit plan…pay any current or former directors, officers or employees any amounts not required by existing plans or agreements….

  Among questions raised by this excerpt from the proxy statement are:

  • a. What is meant by the qualifying phrase “with certain exceptions”? Presumably this refers to exceptions noted in connection with Company Forbearances set forth in Section 5.2 of the Merger Agreement as discussed below.
  • b. What is meant by “except with [BofA's] prior written consent”? This phrase implies future consent by BofA. Shareholders, however, were not advised that BofA, in connection with the Merger Agreement, already had approved up to $5.8 billion in discretionary bonuses under the Merrill VICP.

  Section 5.2 of the Merger Agreement reads, in part, as follows:

  5.2 [Merrill] Forbearances. During the period from the date of this Agreement to the Effective Time, except as set forth in this Section 5.2 of the [Merrill] Disclosure Schedule or except as expressly contemplated or permitted by this Agreement, [Merrill] shall not…without the prior written consent of [BofA]…

  This language is followed by approximately 20 actions that, with certain specified exceptions, Merrill agrees not to take without prior written consent of BofA. (These actions, including discretionary bonus payments, were summarized in the proxy statement, as noted above.) Section 5.2(c) of the Merger Agreement in referencing bonuses provides that Merrill will not:
  

  (c) except as required under applicable law or the terms of any Company Benefit Plan…pay any amounts to Employees not required by any current plan or agreement (other than base salary in the ordinary course of business)… [4]

• 3. As noted above, the Company Disclosure Schedule was attached to the Merger Agreement but not included in the materials distributed to shareholders. The relevant portion of the undisclosed Company Disclosure Schedule, according to the SEC complaint in its Aug. 3 action against BofA, provides that incentive bonus amounts under the Merrill VICP “may be awarded at levels that…do not exceed $5.8 billion in aggregate value (inclusive of cash bonuses and the grant date value of long-term incentive awards)….”
• 4. On Dec. 5, 2008, shareholders of both corporations approved the merger.
• 5. On Dec. 17, 2008, Mr. Lewis met with Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke. He advised them that BofA, having discovered large additional losses at Merrill, much greater than anticipated, was considering calling off the merger pursuant to the “Material Adverse Change” (MAC) clause in the Merger Agreement. At some point, at this meeting or within a few days thereafter, Mr. Paulson apparently advised Mr. Lewis that if the merger were called off by BofA, the country’s financial system might be jeopardized and the Government might require that members of BofA’s Board and its top management be removed. Shortly thereafter, BofA decided to proceed with the merger. The information described in this paragraph 5 was not disclosed to shareholders of BofA or Merrill prior to the merger.
• 6. On Jan. 1, 2009, the merger of Merrill and BofA took place.

SEC Litigation Against BofA

• 1. Less than a year after the merger of BofA with Merrill, a number of investigations and litigations are pending in respect of the bonuses awarded by Merrill at the end of December 2008, just prior to the merger on Jan. 1, 2009. [5] These include a lawsuit brought by the Securities and Exchange Commission against BofA on Aug. 3, 2009, in the U.S. District Court (SDNY). [6] The complaint states that BofA had not adequately informed shareholders, prior to the Dec. 5, 2008, vote on the merger with Merrill, of the authorization by BofA of bonus amounts up to $5.8 billion.
• 2. Also on Aug. 3, 2009, BofA consented to a proposed Final Consent Judgment pursuant to which it would pay a civil penalty in the amount of $33 million in settlement of the litigation. [7] In this proposed Final Consent Judgment, BofA expressly denies admission of any wrongdoing. Thus, the parties attempted to settle the lawsuit by agreeing to the proposed Final Consent Judgment on the same day the SEC brought suit.
• 3. On Sept. 14, 2009, U.S. District Judge Jed Rakoff, after seeking further information as to the basis for the settlement and determining that the additional information provided was inadequate, rejected the proposed Final Consent Judgment and ordered a trial to take place commencing Feb. 1, 2010. [8] In the Order, Judge Rakoff makes the following rather colorful statements:
  

  [The proposed Consent Judgment] is not fair, first and foremost, because it does not comport with the most elementary notions of justice and morality, in that it proposes that the shareholders who were the victims of the Bank’s alleged misconduct now pay the penalty for that misconduct….

  * * *

  [I]n all its voluminous papers protesting its innocence, Bank of America never actually provides the Court with the particularized facts that the Court requested, such as precisely how the proxy statement came to be prepared, exactly who made the relevant decisions as to what to include and not include so far as the Merrill bonuses were concerned, etc.…

  * * *

  Overall, indeed, the parties’ submissions, when carefully read, leave the distinct impression that the proposed Consent Judgment was a contrivance designed to provide the S.E.C. with the facade of enforcement and the management of the Bank with a quick resolution of an embarrassing inquiry—all at the expense of the sole alleged victims, the shareholders. Even under the most deferential review, this proposed Consent Judgment cannot remotely be called fair.

  * * *

  [T]he Consent Judgment would effectively close the case without the S.E.C. adequately accounting for why, in contravention of its own policy…it did not pursue charges against either Bank management or the lawyers who allegedly were responsible for the false and misleading proxy statements. [9]

• 4. On Oct. 13, BofA and the SEC entered into a Disclosure Stipulation Agreement and Proposed Protective Order (”Disclosure Agreement”) regarding waiver by BofA of attorney-client privilege regarding certain documents and communications. The Disclosure Agreement became the subject of an order by Judge Rakoff, to which the Disclosure Agreement was attached, dated Oct. 14, 2009. [10] The material subject to the waiver was scheduled to be released shortly after this column was written.

Observations on the Matter

On Jan. 1, 2009, BofA shareholders paid $29.1 billion in BofA stock for a business that had lost $27.6 billion in 2008. The bonuses have become a major issue because of claims that shareholders were misled in exercising their vote on Dec. 5, 2008, by lack of information and/or by misinformation as to the size of the bonuses. Obviously, the overriding economic issue of concern in BofA’s acquisition of Merrill are Merrill’s losses and the price paid by BofA for a company with such staggering losses. [11] (The extent of communication of those losses to shareholders, and resulting investigations and litigations, are beyond the scope of the column.)

It can be argued that shareholders should have been aware that large bonuses would be paid. Even in a loss year like 2007 ($7.8 billion in losses), Merrill had paid substantial bonuses. [12] Through the third quarter of 2008, compensation and benefits, as shown in the published financial statements for Merrill, equaled approximately $11.2 billion; for the entire year 2008, these expenses equaled approximately $14.8 billion. [13]

It also can be argued that even if prior to the filing of the proxy statement it was disclosed that BofA had approved bonuses that “do not exceed $5.8 billion,” BofA shareholders would still not have known what the actual bonus amount would be. (In fact, at the time of filing the proxy statement, no one knew exactly what the amount of bonuses would be.) And if the shareholders had seen the $5.8 billion cap, would it have materially affected their vote?

On the other hand, BofA shareholders reasonably might have expected they would be furnished some specific numbers on the projected bonus amounts at Merrill as part of the information on which to base their vote. It would be a reasonable assumption that some employees would receive bonuses based on outstanding individual and unit performance even in a year in which, overall, the employer had losses. But in a year of staggering losses for Merrill (which, as noted, by year-end reached $27.6 billion), presumably shareholders, without specific numbers, generally would not have realized that approximately $3.6 billion in discretionary bonuses would be paid.

As also noted above, at the time this column was written, materials previously withheld by BofA under attorney-client privilege were being released pursuant to waiver by BofA. Whatever those materials may disclose, it is clear that BofA shareholders lacked an adequate picture of the projected bonus amounts. This suggests that, in addition to its current litigation against BofA before Judge Rakoff, the SEC should reexamine its procedures as to disclosure of information to shareholders regarding potential bonus amounts for the year in which a merger or acquisition occurs.

Endnotes:

[1] The actual merger involved the merger of a newly created subsidiary of BofA, MER Merger Corporation, into Merrill Lynch & Co. Inc. Merrill Lynch & Co. Inc. as the survivor became a subsidiary of BofA.
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[2] The column does not discuss in any depth issues involving the staggering losses of Merrill for 2008 and why disclosure of spiraling year-end losses were not made before the merger took place Jan. 1, 2009.
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[3] Other firms also faced crises. Citigroup, Goldman Sachs and Morgan Stanley, for example, experienced precipitous falls in stock price. Much of this pressure had to do with short selling, which has been thought to be responsible for a significant portion of the drop.
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[4] This excerpt from the Merger Agreement uses the term “Employees” to reference not only employees but also directors and officers of Merrill or its subsidiaries, thus incorporating the same groups as referenced by the proxy statement in its summary.
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[5] Investigations of Merrill bonuses have included an investigation by New York State Attorney General Andrew Cuomo and by the U.S. House of Representatives Committee on Oversight and Government Reform. At least one shareholders’ derivative suit is pending in the Delaware Court of Chancery involving the bonus issue. See In re: Bank of America Corp. Stockholder Derivative Litigation, No. 4307-VCS, (Del. Ct. Ch). The Ohio Attorney General (on behalf of certain pension funds) is involved in another action pending in the U.S. District Court for the Southern District of New York. See In re Bank of Am. Corp. Sec., Deriv. & ERISA Litig., No. 09-MDL-2058 (S.D.N.Y.).
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[6] Complaint, Securities and Exchange Commission v. Bank of America Corp., No. 09 Civ. 06829 (S.D.N.Y. Aug. 3, 2009). The SEC had been notified of concerns by Congress and others over the lack of disclosure of potential bonus amounts to shareholders prior to the Aug. 3, 2009, action. See, for example, letters exchanged by Representative Dennis J. Kucinich as chairman of the Domestic Policy Subcommittee of the House Oversight Committee (letter dated April 6, 2009) and Mary L. Schapiro as chairman of the SEC (letter dated April 10, 2009).
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[7] Proposed Final Consent Judgment as to Defendant Bank of America Corporation, Securities and Exchange Commission v. Bank of America Corp., No. 09 Civ. 06829 (S.D.N.Y. Aug. 3, 2009).
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[8] Securities and Exchange Commission v. Bank of America Corp., No. 09 Civ. 06829 (S.D.N.Y. Sept. 14, 2009) (Order of the court rejecting proposed settlement); see also Securities and Exchange Commission v. Bank of America Corp., No. 09 Civ. 06829 (S.D.N.Y. Sept. 22, 2009) (Order of the court adjourning trial date to March 1, 2010).
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[9] Securities and Exchange Commission v. Bank of America Corp., No. 09 Civ. 06829 (S.D.N.Y. Sept. 14, 2009) (Order of the court). In footnote 1 to the Order, Judge Rakoff makes observations regarding the source of the funds needed to pay the $33 million penalty as well as the funds needed to pay bonuses to the executives. Footnote 1 reads as follows:

Undoubtedly, the decision to spend this money was made even easier by the fact that the U.S. Government provided the Bank of America with a $40 billion or so “bail out,” of which $20 billion came after the merger. Since $3.6 billion of that money had already been spent, indirectly, to compensate the Bank for the Merrill bonuses—not to mention the $20 billion in taxpayer funds that effectively compensated the Bank for the last-minute revelations that Merrill’s loss for 2008 was $27 billion instead of $7 billion—what impediment could there be to paying a mere $33 million (—or more than most people will see in their lifetimes—) to get rid of a lawsuit saying that the bonuses had been concealed from the shareholders approving the merger? To say, as the Bank now does, that the $33 million does not come directly from U.S. funds is simply to ignore the overall economics of the Bank’s situation.

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[10] Securities and Exchange Commission v. Bank of America Corp., No. 09 Civ. 06829 (S.D.N.Y. Oct. 14, 2009) (Order of the court). The intent of BofA apparently was to waive the privilege also as to certain ongoing state and federal investigations. At least one commentator has questioned whether the effect of the handing over of materials by BofA to the SEC may constitute a waiver as to assertion of the privilege in other proceedings not intended to be covered, including private litigation. See Zach Lowe, “Did BofA Mess Up Its Privilege Waiver?” American Lawyer, Oct. 20, 2009, http://www.law.com/jsp/article.jsp?id=1202434746211&Did_Bank_of_America_Mess_Up_Its_Privilege_Waiver.
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[11] BofA shareholders as well as other parties, including Congressional Committees and New York Attorney General Cuomo, have charged that BofA shareholders were misled in voting approval of the merger by lack of information as to spiraling losses. Angering and frustrating as lack of such information must have been to shareholders in connection with the Dec. 5 vote, anger and frustration must have been equal if not greater over the lack of information regarding further spiraling losses during December after the vote and before the merger. Information not shared with shareholders during this latter period included the apparent intent of the BofA Board during a period in December ending with discussions with the Government to invoke the MAC clause and terminate the merger. As noted in the text, after discussions with Treasury Secretary Paulson and Federal Reserve Chairman Bernanke, in light of the Government’s vehement opposition to a termination of the merger, BofA completed the merger with Merrill Jan. 1, 2009.
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[12] See, for example, Merrill’s 10-K for its fiscal year 2008, Part II, Item 7, p. 24 (Feb. 24, 2009) where it is stated,

Compensation and benefits expenses were $14.8 billion in 2008 and $15.9 billion in 2007. The year over year decrease primarily reflects lower incentive-based compensation costs as a result of lower net revenues and net earnings, as well as reduced headcount levels. The overall decrease in compensation and benefits expense was driven by a 30% decline in incentive-based compensation, partially offset by increased amortization of prior year stock compensation awards.

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[13] The compensation and benefits given in the text are as reported, respectively, in Merrill’s 10-Q for its third quarter and its 10-K for its fiscal year 2008.
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A year after the United States government allowed the investment bank Lehman Brothers to fail but then bailed out AIG, and after governments around the world bailed out many other banks, key question remains: when and how should authorities rescue financial institutions?

It is now widely expected that, when a financial institution is deemed “too big to fail,” governments will intervene if it gets into trouble. But how far should such interventions go? In contrast to the recent rash of bailouts, future government bailouts should protect only some creditors of a bailed-out institution. In particular, the government’s safety net should never be extended to include the bondholders of such institutions.

In the past, government bailouts have typically protected all contributors of capital of a rescued bank other than shareholders. Shareholders were often required to suffer losses or were even wiped out, but bondholders were generally saved by the government’s infusion of cash.

For example, bondholders were fully covered in the bailouts of AIG, Bank of America, Citigroup, and Fannie Mae, while these firms’ shareholders had to bear large losses. The same was true in government bailouts in the United Kingdom, Continental Europe, and elsewhere. Bondholders were saved because governments generally chose to infuse cash in exchange for common or preferred shares – which are subordinate to bondholders’ claims – or to improve balance sheets by buying or guaranteeing the value of assets.

A government may wish to bail out a financial institution and provide protection to its creditors for two reasons. First, with respect to depositors or other creditors that are free to withdraw their capital on short notice, a protective government umbrella might be necessary to prevent inefficient “runs” on the institution’s assets that could trigger similar runs at other institutions.

Second, most small creditors are “non-adjusting,” in the sense that they are unable to monitor and study the financial institution’s situation when agreeing to do business with it. To enable small creditors to use the financial system, it might be efficient for the government to guarantee (explicitly or implicitly) their claims.

But, while these considerations provide a basis for providing full protection to depositors and other depositor-like creditors when a financial institution is bailed out, they do not justify extending such protection to bondholders.

Unlike depositors, bondholders generally are not free to withdraw their capital on short notice. They are paid at a contractually specified time, which may be years away. Thus, if a financial firm appears to have difficulties, its bondholders cannot stage a run on its assets and how these bondholders fare cannot be expected to trigger runs by bondholders in other companies.

Moreover, when providing their capital to a financial firm, bondholders can generally be expected to obtain contractual terms that reflect the risks they face. Indeed, the need to compensate bondholders for risks could provide market discipline: when financial firms operate in ways that can be expected to produce increased risks down the road, they should expect to “pay” with, say, higher interest rates or tighter conditions.

But this source of market discipline would cease to work if the government’s protective umbrella were perceived to extend to bondholders. If bondholders knew that the government would protect them, they would not insist on getting stricter contractual terms when they face greater risks. The problem of “moral hazard” – which posits that actors will take excessive risks if they do not expect to bear fully the consequences of their actions – is commonly cited as a reason not to protect shareholders of bailed-out firms. But it also counsels against protecting firms’ bondholders.

Thus, when a large financial firm runs into problems that require a government bailout, the government should be prepared to provide a safety net to depositors and depositor-like creditors, but not to bondholders. In particular, if the firm’s equity capital erodes, the government should not provide funds (directly or indirectly) to increase the cushion available to bondholders. Rather, bonds should be at least partly converted into equity capital, and any infusion of new capital by the government should be in exchange for securities that are senior to those of existing bondholders.

Governments should not only avoid protecting bondholders after the fact, when the details of a bailout are worked out; but should also make their commitment to this approach clear in advance. Some of the benefits of a government policy that induces bondholders to insist on stricter terms when financial firms take larger risks would not be fully realized if bondholders believed that the government might protect their interests in the event of a bailout.

In other words, governments should establish bailout policies before the need to intervene arises, rather than make ad hoc decisions when financial firms get into trouble. The best policy should categorically exclude bondholders from the set of potential beneficiaries of government bailouts. This would not only eliminate some of the unnecessary costs of government bailouts, but would also reduce their incidence.

Effective January 1, 2010 brokerage firms will no longer be able to vote for non-responding clients with regard to uncontested elections of directors as a result of the SEC’s recent approval of Amended NYSE Rule 452. Also, for many years corporations have complained about a lack of access to the names of all of their beneficial owners. Finding ways to deal effectively with these issues is now of significant importance to public companies of all sizes.

Our proposal to the SEC suggests certain reforms to the proxy voting system. Among the key issues which we propose the SEC take action on are the following 5 points:

• 1. First and foremost, a new methodology called ABO (i.e., All Beneficial Owners) should replace the current NOBO/OBO mechanism which has existed for 25 years, at least with regard to record dates for annual or special meetings.
• 2. The SEC should seek to authorize the establishment of a second mail and tabulation methodology, one that would give companies the ability (using the names available under ABO) to choose a different vendor to take responsibility for the mailing and tabulation process, while retaining the option to use the current Broadridge system. This new option would be akin to the way most companies currently use their transfer agent to mail and tabulate the votes of registered owners.
• 3. The SEC should require the NYSE to implement as quickly as possible a robust investor education program to try and ameliorate at least some of the impact resulting from the loss of broker voting on non-contested director elections under Amended NYSE Rule 452.
• 4. The SEC should amend Rule 13(f) so that information reported by institutions reflects both shares owned and also voting rights after taking into account loans and other transactions that alter such rights. We also suggest shortening the reporting period for 13(f) information to 15 days from 45 days after the end of a calendar quarter and reducing from 20 to 10 business days the pre-notification of a company’s annual meeting record date.
• 5. The SEC should establish new procedures to deal with issues like “empty voting” and the use of derivative positions to alter voting rights.

Difference of opinion would be obviously valuable if it inherently entails a productive advantage in the sense of bringing new ideas or insights that would otherwise be unavailable. But could it be valuable even when it brings no direct productive advantage? Moreover, are there any costs of people having differing opinions? In our forthcoming Journal of Political Economy paper entitled Opinions as Incentives, we explore these questions by examining the incentive implications of difference of opinion.

We employ a framework that captures common themes encountered by many organizations.  More specifically, we study a setting in which a decision maker, or DM for short, consults an adviser before making a decision. Both individuals’ payoff from the decision depends on some exogenous state of the world. We model the decision and the state as real numbers, where the DM’s payoff-maximizing decision is equal to the state. At the outset, however, neither the DM nor the adviser knows the state; they only hold some prior views about it. The adviser can exert costly effort to try and discover an informative signal about the state; the probability of observing such a signal is increasing in his effort. Effort is unverifiable, however, and higher effort imposes a greater cost on the adviser. After the adviser privately observes the information, he strategically communicates with the DM. Communication takes the form of verifiable disclosure: sending a message is costless, but the adviser cannot falsify information, or equivalently, the DM can judge objectively what a signal means. The adviser’s strategic choice therefore is whether or not to reveal any information he has acquired. Finally, the DM makes her decision given her updated beliefs after communication with the adviser.

Our main results concern a tradeoff associated with difference of opinion. To see the intuition, suppose first that effort is not a choice variable for the adviser. In this case, the DM has no reason to prefer an adviser with a differing opinion. In fact, unless the signal is perfectly informative about the state, the DM will strictly prefer a like-minded adviser, i.e. one with the same opinion as she has. This is because agents with different opinions will hold different posteriors about what the right decision is given a partially informative signal. Consequently, even though he shares the same fundamental preferences, an adviser with a differing opinion will typically withhold some information from the DM. This strategic withholding of information entails a welfare loss for the DM, whereas no such loss will arise if the adviser is like-minded. When effort is endogenous, the DM is also concerned with the adviser’s incentive to exert effort; all else equal, she would prefer an adviser who will exert more effort. We find that differences of opinion create incentives for information acquisition, for two distinct reasons. First, an adviser with a difference of opinion is motivated to persuade the DM. This motive does not exist for a like-minded adviser. Second, and more subtle, an adviser with a difference of opinion will exert effort to avoid rational prejudice. Consequently, an adviser with a difference of opinion has incentives to seek out information in order to avoid an adverse inference from the DM, a motive that does not exist for a like-minded adviser.

Equipped with this central tradeoff, we then refine our analysis to obtain two results that apply specifically to organization economics.

First, assuming that the DM can choose an adviser from a rich pool of different opinion types (including a like-minded type), we find that the DM should select an adviser with some difference of opinion over a perfectly like-minded one. The reason is that an adviser with a sufficiently small difference of opinion engages in only a negligible amount of strategic withholding of information, so the loss associated with such an adviser is negligible. By the same token, the prejudicial effect and its beneficial impact on information acquisition is also negligible when the difference of opinion is small. In contrast, the persuasion motive that even a slight difference of opinion generates and thus the benefit the DM enjoys from its impact on increased effort is non-negligible by comparison. Therefore, the DM derives a net benefit from an adviser with at least a little difference in opinion.

Second, we argue that lack of congruence (in terms of prior opinions, but also, to a lesser degree, preferences) can be beneficial to an organization, and this benefit can be harnessed only when authority remains in the hands of the principal. The reason is that delegation can be de-motivating for the adviser because it eliminates both incentive effects we have highlighted: the desire to persuade the DM and to avoid prejudice. The conclusion that emerges is a more nuanced view of how delegation affects initiative from the agent.

While we focus primarily on difference of opinion, we augment the model later in the paper to allow the adviser to also differ from the DM in preferences over decisions.

The full paper is available for download here.

Bebchuk’s report is available here. An article focusing on the report published by Haaretz, one of Israel’s main newspapers, is available here (in Hebrew).

The events of 2008 clearly exposed the vulnerabilities of financial firms whose business models depended too heavily on uninterrupted access to secured financing markets, often at excessively high leverage levels. This dependence reflected an unrealistic assessment of liquidity risks of concentrated positions and an inability to anticipate a dramatic reduction in the availability of secured funding to support these assets under stressed conditions. A major failure that contributed to the development of these business models was weakness in funds transfer pricing practices for assets that were illiquid or significantly concentrated when the firm took on the exposure. Some improvements have been made, but instituting further necessary improvements in liquidity risk management must remain a key priority for financial services firms.

The Senior Supervisors Group (SSG), a group of senior financial supervisors from seven countries of which I am Chairman, recently forwarded a report to the Financial Stability Board entitled Risk Management Lessons from the Global Banking Crisis of 2008. The report reviews in depth the funding and liquidity issues central to the recent crisis and explores critical areas of risk management practice warranting improvement across the financial services industry. The report is a companion and successor to the SSG’s first report, Observations on Risk Management Practices during the Recent Market Turbulence, issued in March 2008.

In the report, we identify various other deficiencies in the governance, firm management, risk management, and internal control programs that contributed to, or were revealed by, the financial and banking crisis of 2008. Our report highlights a number of areas of weakness that require further work by the firms to address, including the following (in addition to the liquidity risk management issues described above):

• the failure of some boards of directors and senior managers to establish, measure, and adhere to a level of risk acceptable to the firm;
• compensation programs that conflicted with the control objectives of the firm;
• inadequate and often fragmented technological infrastructures that hindered effective risk identification and measurement; and
• institutional arrangements that conferred status and influence on risk takers at the expense of independent risk managers and control personnel.

In highlighting the areas where firms must make further progress, we seek to raise awareness of the continuing weaknesses in risk management practice across the industry and to evaluate critically firms’ efforts to address these weaknesses. Moreover, the observations in this report support the ongoing efforts of supervisory agencies to define policies that enhance financial institution resilience and promote global financial stability.

This analysis builds upon the first SSG report, which identified a number of risk management practices that enabled some global financial services organizations to withstand market stresses better than others through the end of 2007. The extraordinary market developments that transpired following the release of the first report prompted the SSG to launch two new initiatives. First, the group conducted interviews with thirteen firms at the end of 2008 to review specific funding and liquidity risk management challenges faced, and lessons learned, during the year. Second, in our supervisory capacities, we asked twenty global financial institutions in our respective jurisdictions to assess during the first quarter of 2009 their risk management practices against a compilation of recommendations and observations drawn from several industry and supervisory studies published in 2008. During the spring of 2009, SSG members reviewed the assessments and held follow-up interviews with fifteen of these firms to explore areas of continued weakness, as well as changes to practice undertaken recently. This report presents the SSG’s primary findings from these initiatives.

In their self-assessments, firms generally indicated that they had either fully or partially complied with most of the recommendations. SSG members, however, found that the assessments were, in aggregate, too positive and that firms still had substantial work to do before they could achieve complete alignment with the recommendations and observations of the studies. In particular, supervisors believe that a full and ongoing commitment to risk control by management, as well as the dedication of considerable resources toward developing the necessary information technology infrastructure, will be required to ensure that the gaps between actual and recommended practice are closed in a manner that is robust and, especially important, sustainable.

We hope the report will call attention to critical areas of risk management in which further effort is warranted.

On October 22, 2009, the Board of Governors of the Federal Reserve System (the “Federal Reserve”) issued a comprehensive proposal (the “Proposal”) on incentive compensation policies that is intended to ensure that these policies do not undermine the safety and soundness of banking organizations by encouraging excessive risk-taking. The Proposal applies to all banking organizations supervised by the Federal Reserve (U.S. bank holding companies, state member banks, Edge and agreement corporations, and the U.S. operations (including securities subsidiaries) of foreign banks with a branch, agency, or “commercial lending company” subsidiary in the United States (each a “banking organization”)). It covers executive and non-executive employees who receive any current or potential compensation that is tied to achievement of one or more performance metrics, as well as “golden parachute” and “golden handshake” arrangements.

The Proposal is based on three key principles that are designed to govern incentive compensation arrangements. There are no prescriptive requirements, such as “caps” or “claw backs”, but there is extensive guidance as to the development, implementation and relevant considerations for these arrangements.

The Proposal imposes immediate obligations on banking organizations to review their incentive compensation arrangements. In addition, the Proposal includes two supervisory initiatives. The first applies to 28 large, complex banking organizations (“LCBOs”), and the second applies to all other banking organizations. In each case, the Federal Reserve will review the banking organization’s policies and practices to determine their consistency with the principles established by the Federal Reserve for risk-appropriate incentive compensation. Deficiencies will be factored into the organization’s supervisory ratings. Compliance with the Proposal is likely to require a significant dedication of resources to develop and implement the requisite internal reviews, policies, reports, systems and controls.

The Federal Reserve requests comments on the Proposal within 30 days after publication in the Federal Register.

I. Background

The Proposal represents, as described by Federal Reserve Governor Daniel Tarullo, “one part of a broad program by the Federal Reserve to strengthen the supervision of banks and bank holding companies in the wake of the financial crisis”. It reflects the Federal Reserve’s view that “[f]laws in incentive compensation practices were one of many factors contributing to the financial crisis”. In the words of Federal Reserve Chairman Bernanke, “[c]ompensation practices at some banking organizations have led to misaligned incentives and excessive risk-taking, contributing to bank losses and financial instability”.

The Proposal explains that supervisory action is also necessary to address the “first mover” problem. The Federal Reserve is concerned that individual firms will be reluctant to act alone to deal with misaligned incentive programs due to concern about losing valuable employees.

The Proposal is designed to be consistent with the Financial Stability Board’s (“FSB”) Principles for Sound Compensation Practices issued in April 2009 and the FSB’s Implementation Standards issued in September 2009. The Proposal notes the Federal Reserve’s intention to work with other nations to achieve a “level playing field”.

II. Proposal

A. Incentive Compensation Principles

The Proposal sets forth three key principles for incentive compensation arrangements that are designed to help ensure that incentive compensation policies do not encourage excessive risk-taking and are consistent with the safety and soundness of banking organizations. The three principles provide that a banking organization’s incentive compensation arrangements should:

• Provide incentives that do not encourage risk-taking beyond the organization’s ability to effectively identify and manage risks.
• Be compatible with effective internal controls and risk management.
• Be supported by strong corporate governance, including active and effective oversight by the organization’s board of directors.

The Proposal indicates that the Federal Reserve expects all banking organizations to evaluate their incentive compensation arrangements based on these three principles. Where there are deficiencies in the incentive compensation arrangements, they must be immediately addressed.

The Proposal explicitly rejects a “one size fits all” approach, and specific limits or requirements, such as pay caps, “claw backs” or allocation between cash and equity, are not included. The Proposal distinguishes supervisory guidance from a formal rule, but the practical effect in individual cases is likely to be similar.

B. Covered Employees

The Proposal covers all employees “who have the ability to materially affect the risk profile of an organization, either individually, or as part of a group”. It explicitly notes that “problematic compensation practices were not limited to the most senior executives”. Covered employees are divided into three segments:

• Senior executives and other employees who are responsible for the oversight of a banking organization’s firm-wide activities or material business lines.
• Individual employees, including non-executive employees, whose activities may expose the banking organization to significant amounts of risk. (An example cited in the Proposal is traders with large positions relative to the banking organization’s overall risk tolerance.)
• Groups of employees who are subject to similar incentive compensation arrangements and who, in the aggregate, may expose the banking organization to significant amounts of risk, even if no individual employee is likely to expose the banking organization to a significant amount of risk. (An example cited in the Proposal is loan officers who, as a group, originate loans that account for a material amount of the organization’s credit risk.)

C. Balanced Risk-Taking Incentive Compensation Arrangements

The Proposal provides that incentive compensation arrangements should “balance risk and financial results in a manner that does not provide employees incentives to take excessive risks”. A balanced incentive compensation arrangement is described as an arrangement that takes into account the risks and financial benefits from the employee’s activities and the impact of those activities on the banking organization’s safety and soundness. As an example, the Proposal states that two employees who generated the same amount of short-term revenue should not receive the same amount of incentive compensation if the risks taken to generate that revenue differ materially.

To determine whether incentives encourage risk-taking beyond a banking organization’s ability to identify and manage the risk and to implement balanced risk-taking incentives, the Proposal provides a number of guidelines:

• Banking organizations should consider the full range of risks (including, credit, market, liquidity, operational, compliance and reputational) associated with an employee’s activities, as well as the time period over which the risks may be realized.
• The relevant time horizon for a risk outcome may extend beyond the stated maturity of an exposure, and special concern should be directed to “bad-tail” risks, i.e., those that have a low probability of being realized but have highly adverse effects if they are.
• There is an important distinction between “reliable” quantitative measures that are available for some risks and “informed judgment” that is used for other risks. In the latter case, there is a “need for strong internal controls and ex post facto monitoring”.
• Banking organizations, particularly LCBOs, should consider using “scenario analysis”.
• Unbalanced incentive arrangements may be moved toward balance by a variety of methods: risk-adjusting the payments, deferring payment so as to adjust actual payments based on actual outcomes, lengthening performance periods, and reducing sensitivity to short-term performance, including reducing the rate at which awards increase as higher levels of performance are achieved. The Proposal cautions against over-reliance on judgment in determining deferrals, as compared to determining deferrals formulaically, because “extensive use of judgment might make it more difficult to execute deferral arrangements in a sufficiently predictable fashion to influence employee behavior”.
• Incentive arrangements should take into account differences among employees, particularly the difference between senior executives and other employees. In this regard, the Proposal notes that equity compensation may not be expected to be as effective in restraining risk incentives for lower level employees as for senior executives; that for senior executives at LCBOs incentive compensation arrangements are likely to be better balanced if they involve deferral of a “substantial portion” of incentive compensation over a multi-year period and payment of a “significant portion” in equity-based instruments vesting over multiple years; and that a single formulaic approach is likely to encourage at least some employees to take excessive risk.
• Careful consideration should be given to how “golden parachutes” and the vesting of deferred compensation may affect risk-taking behavior. For senior executives, the Proposal notes that forfeiture provisions may be counterproductive, especially in a competitive marketplace where sign-on bonuses are prevalent.
• Banking organizations should effectively communicate to employees the ways that incentives will be reduced as risks increase.

D. Compatibility with Effective Control and Risk Management

The Proposal states that a banking organization’s internal risk-management processes and controls should reinforce and support the development and continuation of balanced incentive compensation arrangements. The Proposal suggests:

• Appropriate controls should be in place, such as regular internal audits (or other review), to ensure that the processes for achieving balanced incentives are followed and to protect against evasion by maintaining the integrity of the risk management function. A banking organization should create and maintain sufficient documentation to permit an audit of the banking organization’s processes for establishing, modifying and monitoring incentive compensation arrangements.
• Risk management employees and other appropriate personnel should have input into the organization’s processes for designing incentive compensation arrangements and assessing effectiveness in limiting excessive risk-taking.
• Compensation for employees in risk management and control functions should be sufficient to attract and retain qualified employees and should avoid conflicts of interest (including by not having their incentives based predominantly on the financial performance of the units that they review).
• Incentive arrangements should be monitored and modified to the extent necessary to provide balanced incentives. The Proposal explains that the design and implementation of effective incentive compensation arrangements “is a complex task” and requires the “commitment of adequate resources”.

E. Effective Corporate Governance

The Proposal states that banking organizations should have strong and effective corporate governance to help ensure sound compensation practices. This requirement primarily relates to a banking organization’s board of directors and board committees but also includes guidance related to processes for designing incentive compensation and disclosure to shareholders of pay practices. The Proposal states that directors should:

• Actively oversee incentive compensation arrangements. The Proposal provides that the board is “ultimately responsible” for ensuring that a banking organization’s incentive compensation arrangements do not jeopardize its safety and soundness. Among the board’s responsibilities are “review and approv[al] of the overall goals and purposes” of the incentive compensation arrangements, “clear direction” to management, “ensur[ing] that the compensation system” will “achieve balance”, direct approval of incentive compensation arrangements for senior executives, and approval and documentation of material exceptions.
• Monitor the performance, and regularly review the design and function, of incentive compensation, including on both a backward and forward-looking scenario basis. In this connection, the board should receive, at least annually, assessments by management.
• Have the organization, composition and resources in order to achieve effective oversight of incentive compensation. At least one member of the compensation committee should have a level of experience and expertise in risk management and compensation practices in financial services that is appropriate for the organization’s activities. The board should also have the authority to select and compensate outside counsel and executive compensation and risk management consultants as needed, and, in that connection, the board should be sensitive to independence issues.

LCBOs should use a systematic approach to developing a compensation system supported by formal internal policies and procedures.

Disclosure to shareholders of incentive compensation arrangements should appropriately describe such arrangements and related risk management, control and governance processes to allow them to “monitor and, where appropriate, take actions to restrain the potential for such arrangements and processes to encourage employees to take excessive risks”. The last statement may be an implicit endorsement of “say-on-pay”. The Proposal notes that the Federal Reserve will work with the Securities Commission to improve disclosure regarding incentive compensation arrangements.

F. Implementation Initiatives and Consequences

Although the Proposal is subject to comment for 30 days, banking organizations are instructed to begin an immediate review of their incentive compensation policies to ensure that they do not encourage excessive risk-taking and implement corrective programs as needed. This review should be based on the Proposal’s three key principles. It is intended to help prepare banking organizations for the Federal Reserve’s two supervisory initiatives, which are intended to spur and monitor the financial industry’s progress toward implementing the Proposal.

The first initiative is a special, coordinated “horizontal” review of the incentive compensation policies and practices of the 28 LCBOs, which will “commence promptly”. In the Federal Reserve’s view, these organizations are significant users of incentive compensation arrangements and flawed arrangements at these organizations are more likely to have a more serious effect on the broader financial system. The horizontal review, which appears to be similar in form to the recently conducted “stress test” at 19 large bank holding companies, will be led by Federal Reserve staff, who will work with relevant Reserve Bank supervisors. As part of this initiative, LCBOs will be expected to provide the Federal Reserve with information and documentation that describes (i) the structure of the banking organization’s current incentive compensation arrangements, (ii) the current processes used by the organization to oversee the arrangements and help ensure that they do not encourage excessive risk and (iii) the organization’s plans, including timetables, for improving risk sensitivity and related risk management, controls and corporate governance practices. The policies and implementing practices of each LCBO will become part of supervisory expectations for it and will be monitored to ensure “full implement[ation] in a timely manner”. The objectives of the horizontal review are to:

• Enhance supervisory understanding of the details of current practices, as well as the steps taken or proposed to be taken by organizations to improve the balance of incentive compensation arrangements.
• Assess the strength of controls and whether actual payouts under incentive compensation arrangements are effectively monitored relative to actual risk outcomes.
• Understand the role played by boards of directors, compensation committees, and riskmanagement functions in designing, approving, and monitoring incentive compensation systems.
• Identify emerging best practices through comparison of practices across organizations and business lines.

Second, the Federal Reserve will review, as part of the regular, risk-focused examination process, the incentive compensation arrangements of banking organizations that are not LCBOs. These reviews will be tailored to each organization based on the scope and complexity of the organization’s activities and the prevalence of incentive compensation arrangements.

The findings of the supervisory initiatives will be included in reports of examination. Deficiencies will be incorporated into the organization’s supervisory ratings, “which can affect the organization’s ability to make acquisitions”. Enforcement actions may be taken against a banking organization if its incentive compensation arrangements, or related risk-management control or governance processes, pose a risk to the organization’s safety and soundness and the organization is not taking prompt and effective measures to correct the deficiencies.

Both supervisory initiatives will aid the Federal Reserve in identifying best practices for incentive compensation for banking organizations.

G. Foreign Banks

In the case of the U.S. operations of foreign banks, the U.S. incentive compensation policies are to be (i) coordinated with the bank’s group-wide policies, (ii) developed in accordance with the rules of the bank’s home country supervisor, and (iii) consistent with the bank’s overall corporate and risk management structure and controls.

H. Comment

The Proposal invites comment on all its aspects, including the guiding three principles, legal and regulatory issues, burden, exceptions (such as for firm-wide profit sharing plans) and formulaic limits (referring to suggestions that at least 60% of all incentive compensation be deferred and at least 50% be equity-linked). The Proposal also inquires as to what statutory, regulatory or private sector actions might mitigate market forces.

III. Conclusion and Observations

The general approach of the Proposal does not depart materially from previous broad statements of policy by the Administration and Federal Reserve. It does, however, provide considerable detail regarding the types of internal processes that are expected to be implemented by banking organizations to monitor risk associated with incentive compensation arrangements throughout the organization. Substantial resources will be needed for banking organizations to align their incentive compensation policies with the Proposal and demonstrate such alignment to Federal Reserve examiners. The Proposal and the Federal Reserve’s oversight are likely to result in greater uniformity of incentive compensation arrangements across organizations with similar risk profiles.

One fundamental question raised by the Proposal is whether banking organizations are being encouraged to weight compensation more heavily to fixed salaries. Although the Proposal acknowledges that incentive compensation has numerous benefits, the attendant risks identified by the Federal Reserve may prove determinative. Such a change, however, would be inconsistent with other compensation initiatives that promote greater focus on performance.

Finally, the Proposal stresses that the development of incentive compensation arrangements will be an evolving process extending over many years. The Federal Reserve will prepare a report after 2010 on trends and developments.

Right now there are many voices clamoring to be heard regarding financial reform. This clamor is composed of some recommendations that are intuitive and others that are not. There are those calling for reforms that are limited to the factors that contributed to the crisis and others who see the possibility of broader legislative and administrative action as an opportunity. Some see it as an opportunity to advance their existing commercial interests, and others, like me, see it as an opportunity to reestablish a comprehensive, but flexible, capital markets regulatory framework that can better react to current and future events.

I think it is important to step back and think through the principles that should motivate any proposed reforms. As a regulator standing on the precipice of legislative and administrative action, I think it is important to focus on how things should be rather than how they are. Rahm Emmanuel’s oft-quoted remark that we should not waste a good crisis is absolutely right. I firmly hope that the opportunity will not be wasted. Unfortunately, it is clear that some transformational changes are no longer on the table — such as a merger of the SEC and CFTC. In addition, there are robust efforts underway to scale back the Obama Administration’s effort to regulate the multi-trillion dollar over-the-counter derivatives industry.

My goal for today’s remarks is to discuss an appropriate construct for financial reform and to consider examples from the current debate that exemplify these principles.

My Experience and Perspective

As I look around this room, let me just say that it is a pleasure to be with a group of leaders in the investment management industry. I feel that I am among friends. While I have spent much of my professional career involved in capital formation though public and private offerings, a substantial portion of my career has been spent working in the investment management industry. As some of you know, my experience with the securities industry began in the late 1970s. After three years with the SEC, I spent the bulk of my thirty years as a practitioner focusing on the capital markets. Although many of those years were in private practice in large law firms, I spent most of the nineties and the early part of this decade as General Counsel and Head of Compliance of a large global asset manager.

Having spent my career in the securities arena — but outside of the Beltway — I have often been asked about my transition to DC life. My timing could not have come at a more interesting time. I began my service on the Commission during “transformational” times to put it mildly. I took office at the end of July 2008 and the past fourteen months have been filled with unprecedented events and government action. There is no question that I am serving as an SEC Commissioner at a time when the financial services industry and its regulators are in dire need of reform. In fact, financial reform has unprecedented attention from the White House, Capitol Hill, the media, and the American public — financial reform is generating articles nearly every day on the front page of the Wall Street Journal, the New York Times, and the Washington Post. The opportunity to institute real reform is here and our efforts should be motivated by the proper principles of investor protection and maintaining fair and orderly markets.

Smart, Effective Regulation is Necessary for Strong Capital Markets

In recent remarks by President Obama regarding the role of government in the health care reform movement, he said,

“You see our predecessors understood that government could not, and should not, solve every problem. They understood that there are instances where the gains in security from government action are not worth the added constraints on our freedom. But they also understood that the danger of too much government is matched by the perils of too little, that without the leavening hand of wise policy, markets can crash, monopolies can stifle competition, and the vulnerable can be exploited.” [1]

I agree wholeheartedly with President Obama. Clearly, smart, effective regulation and oversight are necessary building blocks in the foundation for robust and fair capital markets.

But it is not just the laws and rules on the books. It is the fact that historically for decades there has been strong enforcement of these laws. Part of the analysis of what went wrong over this last decade is that many of the appropriate regulators possessed authority to act when they saw questionable activity — but they made affirmative decisions not to act. In essence, they looked the other way. The argument that the market can discipline itself no longer resonates given the amount of evidence to the contrary. Thus, smart, effective regulation includes both the laws on the books — as well as the will to enforce them.

Take the creation of the Investment Company Act of 1940 as an example. The Act was the product of input from the SEC, the industry, and the Congress and was designed to right the abuses in the investment company industry. At the time, Congress recognized that the full-disclosure approach of the Securities Act of 1933 was insufficient to address the potential abuses that are possible when large pools of assets are entrusted to third parties for investment. As a foundation to develop an effective regulatory framework, Congress authorized the SEC to do a three-year study, commonly referred to as the Investment Trust Study, where the Commission uncompromisingly and comprehensively revealed the actual abuses that had occurred, as well as the inherent potential for abuse in a fund structure. As this audience knows only too well, the ultimate legislation set forth in great detail the standards and prohibitions with which the fund industry would have to comply, while also intelligently vesting discretion in the Commission to grant exemptions.

A year after the passage of the Investment Company Act, Alfred Jaretski, a leading investment company lawyer of the time, wrote,

“. . . [i]t is the conviction of the writer that the enactment of the Investment Company Act of 1940, particularly as the result of a cooperative effort, was of primary benefit to the investment company industry. The Act not only protects investors, but in setting specific standards for management affords protection to officers and directors.” [2]

I agree with Mr. Jaretski that the prescriptions and prohibitions in the Investment Company Act proved beneficial to the industry. I submit that a key factor to the industry flourishing to an estimated $10.6 trillion in assets under management is because the Act was tailored to aggressively eliminate the potential for abuse. Among other things, the Investment Company Act includes minimum capital requirements for companies, prohibits complex capital structures, and prohibits opportunities for “self-dealing” by affiliates. Perhaps even more important is the fact that the Act has been enforced for decades — and that has served to provide a framework for the fund industry that investors and market participants can rely on. The fact that millions of Americans are invested in mutual funds demonstrates the confidence that they have in the fund industry. I believe that a key factor in investors fueling the growth of the industry is that they have had confidence that their assets will be subject to appropriate safeguards. Can you imagine if Congress had enacted the Investment Company Act of 1940 and it was not enforced by the SEC either due to lack of will and/or lack of funds? What would have happened to investor confidence? Where would the fund industry be?

Appropriate Regulatory Construct for Reform

I, for one, remain optimistic about the on-going discussions of fundamental regulatory reform taking place on Capital Hill. I am hopeful that Congress will soon close many of the regulatory gaps that have been painfully highlighted and that it will set the SEC on more solid footing by giving us the ability to have the resources necessary to oversee the Commission’s ever-expanding responsibilities.

Since coming to the Commission, I have been a vocal advocate for the Commission’s mission to protect investors, provide for fair and orderly markets, and promote capital formation. All aspects of this mission guide my thoughts as we consider the appropriate framework to regulate the investment management industry.

Currently, the regulatory landscape in the investment management industry faces potentially dramatic changes from a number of initiatives — including proposals targeting money market funds, investment advisers with custody of assets, and pay-to-play arrangements. In addition, there remain a number of proposals that the Commission has not acted on for the past several years. These include topics as diverse as 12b-1 fees, ETFs, soft dollars, and Form ADV, just to name a few. Moreover, there are discussions that could dramatically impact the industry — from treating all service providers who render investment advice as fiduciaries, to strengthening oversight of advisers, to bringing advisers of pooled funds, such as hedge funds, into the regulatory environment.

As we look to the regulatory proposals on the table and those to come, I think it is vital that each proposal be rigorously analyzed and that the following threshold questions, where applicable, be asked and answered satisfactorily.

• How does this proposal enhance investor protection?
• Does this proposal promote a fair and orderly marketplace?
• Does this proposal prepare for unforeseen developments?
• Is this proposal sustainable over time? Are the requirements in the proposal accompanied by appropriate funding?

Because we have limited time today and there are so many reforms under consideration, I am going to discuss just a few reforms in the investment management arena that illustrate this analysis.

Enhance Investor Protection and Promote Fair and Orderly Markets

Clarifying that Broker-Dealers who Provide Investment Advice are Fiduciaries

Much has been written and spoken, including by me, about the discussions under way about broker-dealers who provide investment advice. Investment advisers have long been recognized to be fiduciaries and, in fact, actively hold themselves out as such. It has been heartening to see that both the Obama Administration in its White Paper, as well as Congressman Kanjorski in the legislation that he introduced last week explicitly state that broker-dealers who provide investment advice should be treated as fiduciaries. Having this codified in legislation will be helpful.

This proposal furthers investor protection in several ways. Up front, the burden will be on the broker-dealer, just as it now is on the investment adviser, to actively put the client’s interest above his or her own and to affirmatively eliminate or mitigate any possible conflicts of interest. A fiduciary standard provides certainty to investors that the person sitting across the table must provide advice that is transparent and in their best interest. You often hear that investors are confused about who is providing them with investment advice, whether it is an adviser or a broker-dealer. The confusion masks the real danger — which is that investors may receive advice and not understand that the broker-dealer or its registered representative did not have the high standard of a fiduciary duty to put their interests first and to disclose certain conflicts.

By extending the fiduciary standard to broker-dealers who provide investment advice, Congress would reduce regulatory arbitrage, and this would allow for consistent regulatory oversight of the same conduct. Moreover, it would enhance the ability of the Commission to enforce this standard going forward. It also would establish a principle focused on how a business interacts with investors, rather than on how a business may be organized — whether as a broker-dealer or investment adviser.

Removal of NRSRO References

Next I would like to touch briefly on the topic of credit rating agencies subject to Commission oversight, known as nationally recognized statistical rating organizations, or NRSROs. Late last year and more recently, in September, the Commission adopted a number of new rules to enhance the regulatory framework for NRSROs and promote transparency, accountability and competition. However, in addition to these new rules, there are also a number of proposals outstanding — including whether to remove NRSRO references from all of the Commission’s rules. Proponents of the removal believe that there is too much reliance on NRSROs and that it is in the interests of investors to remove all NRSRO references from the SEC’s rules. Many others believe, however, that the use of an objective, external evaluation by a properly regulated NRSRO provides protection — and that the better way to resolve concerns about credit ratings is to improve the reliability of the ratings themselves, not merely remove them.

Removing NRSRO references from SEC rules sounds simple in concept but, in execution, it is much more complex. The fundamental question one has to ask relative to each reference is . . . what role does it have within a given rule? Sometimes the use of an NRSRO reference is simply administrative convenience. But, quite often, the answer is investor protection. It needs to be appreciated that many of the rules containing NRSRO references are exemptive in nature — meaning that the rule allows market participants to engage in activity that would otherwise be unlawful. As just one example, many of the Investment Company Act rules containing NRSRO references allow a fund to operate in ways that it otherwise could not. In most of the rules in question, the rating references often function as a condition designed to permit particular conduct — conduct that would otherwise be prohibited, while at the same time preventing possible abuses that could arise from the conduct.

Given that ratings often serve as an investor protection, one has to look hard to understand whether the reference to a credit rating in a rule has a viable alternative that offers equivalent protection, or whether the exemption itself should be rescinded if the reference is removed.

One approach to ratings that has worked well is the one currently used in Rule 2a-7 under the Investment Company Act. In Rule 2a-7, the credit rating sets a floor for the quality of a security but then, in addition, there is a requirement of an internal evaluation. In particular, the Commission, in its recent proposal, is seeking comment on whether Investment Company Act Rules 3a-7 and 5b-3, and Advisers Act Rule 206(3)-3T should do just this by replacing the ratings standard with alternate standards that would (i) use credit ratings as a minimum standard and (ii) require an additional internal determination of credit quality. This approach could reduce undue reliance on ratings by requiring an additional evaluation of credit quality, while retaining the external or objective measure of the NRSRO rating. It is a belt-and-suspenders approach that can benefit the industry — and more importantly, protect investors.

Pay-to-Play

In addition to asking how a proposal impacts on investor protection, we also need to ask how a proposal impacts the promotion of a fair and orderly market. For example, the Commission recently issued a proposal to address investment advisers who make political contributions in order to be chosen to manage public pension fund money — or, in other words, whether the adviser is engaging in a “pay-to-play” arrangement. This is a proposal that addresses investor protection but is also designed to promote a fair and orderly marketplace.

As we discussed earlier, it is well-recognized that investment advisers owe their clients a fiduciary duty to put their clients’ interests above their own. Investment advisers, who seek to win pension business through political contributions, rather than through their qualifications, are violating their fiduciary duty to the plan and its beneficiaries.

Let’s face it — if an adviser wins business because it has “paid” in order to “play,” there are serious doubts as to whether the most qualified adviser was selected for the job. After all, in such a case, the adviser selection process would not appear to be based on merit and qualification. If the best person was not selected for the job, the plan could suffer inferior management that may lead to greater losses. The plan may also be paying higher fees because the adviser may be trying to recoup its political contributions or because the contract negotiations were not exactly arms-length.

The hope with this rule proposal is that, if it is appropriately crafted and tailored, it will benefit both individual investors in pension plans as well as the market as a whole. By prohibiting an adviser’s ability to enhance his or her chances of being hired through inappropriate political contributions, the goal is that all advisers — large and small — will be able to more effectively compete for a slice of the public pension fund business. The focus of any Commission action in this area should ensure that the emphasis is on choosing the most qualified adviser who is best able to fulfill the needs of pension plans and their beneficiaries.

Being Prepared for Unforeseen Developments

With reform proposals, it is important to solve the problem of today but it is just as important to also build a structure that prepares for the crisis of tomorrow. We can see that the drafters of the securities laws did this by granting the Commission significant discretion to promulgate rules, issue exemptions, as well as investigate and enforce the laws. No one in 1940 would have contemplated that we would have a fund industry worth $10.6 trillion. It is my belief that that the regulatory structure created in 1940 has served investors well by providing a legal and regulatory platform for this industry that has allowed innovations but has also simultaneously fostered investor confidence. This has been a key to the industry’s explosive growth.

One area where I fear that the Commission may miss an opportunity to have the flexibility to prepare for the future is in the hedge fund arena. Because it is difficult, if not impossible, to predict today what rules will be required in the future to protect investors and obtain sufficient transparency, especially in an industry as dynamic and creative as hedge funds, the Commission should be actively seeking from Congress broader authority to have additional regulatory flexibility to act in the future. For example, Congress could provide the SEC rule-making authority to condition the use by a hedge fund of the exceptions provided by sections 3(c)(1) and 3(c)(7) of the Investment Company Act. These conditions could enable the Commission to impose those requirements that the Commission believes are necessary or appropriate to protect investors and enhance transparency. This would grant the Commission flexibility to better discharge its responsibilities and to adapt to future market conditions without having to ask Congress for more authority.

Granting the SEC the authority to condition 3(c)(1) and 3(c)(7) to better and more quickly deal with unforeseen events would be wise policy. The SEC has historically used the power to grant and condition exemptions in a responsible and pragmatic way. As those in this room know, money market funds and exchange traded funds would not exist today if not for the SEC’s use of its exemptive authority.

Making Reform Proposals Sustainable by Specifying Resources

Let me now discuss one of the keys to success in regulatory reform. As the discussion of regulatory reform continues it is crucial that efforts be made to ensure that proper resources are made available. Reform proposals must be sustainable over the long haul — and, simply stated, unfunded regulatory mandates will not be. With approximately 3,600 staff, the SEC is currently responsible for approximately 12,000 public companies; 11,300 investment advisers; 950 fund complexes; 5,500 broker-dealers (with over 173,000 branch offices); 600 transfer agents; 11 exchanges; 5 clearing agencies; 10 credit rating agencies; a number of SROs; and, in addition, has oversight over the nation’s financial accounting standards setter, the FASB. When you compare our responsibility with other regulators you can appreciate how understaffed we are. For example, the FDIC had a staff of 5,000 to oversee 5,100 FDIC-insured banks. Without a doubt, you can see that the SEC staff has its hands full.

If we are to have sustainable reforms, the SEC must receive the appropriate staff and technology funding resources to be able to build and execute a strong regulatory program. Otherwise, the reforms are destined to fail and investors and the market will bear the costs of that failure.

It is my belief that the best way to have a viable SEC is to provide it with the ability to budget and self-fund its operations. The SEC needs to be in the position to set multi-year budgets and respond in real time to drastically changing markets, while also maintaining appropriate staffing. Currently, the SEC’s budget is recommended by the President and annually appropriated and apportioned. Consequently, we do not know from year-to-year what funding level will be appropriated. This structure has harmed the agency’s ability to perform its mission in terms of long-range planning, developing necessary technology and maintaining appropriate staffing levels.

It is important for everyone to realize it is not just the amount of resources that is important, but also the timing of when those resources are received. In my fourteen months as a Commissioner, the agency and the markets have experienced the worst economic crisis in decades. In response, while the SEC is engaged in some restructuring, most notably in our Division of Enforcement, there is much more that should be done. As I travel the country, I meet people who assume that the agency is responding to the crisis by engaging in radical hiring, re-structuring, and the acquisition of state-of-the-art technology. People are shocked to find out that the agency has not done any of these things in any significant way — simply because it can not. We just do not have the resources.

Since taking my oath as a Commissioner, I have been a passionate advocate for the SEC to be self-funded. Basically, as soon as I arrived at the Commission, it became apparent to me that the SEC’s technology infrastructure and strategic planning capacity were threadbare in large part because of how the SEC is funded. This was highlighted when I attended a staff demonstration of surveillance technology that was clearly in serious need of updating and was shocked to learn of the difficulties that the staff was having in getting it updated. In fact, the system had to be taken off line for almost a year — simply because the SEC did not receive enough funding. I believe the American public deserves better.

I have been heartened by the supportive statements made by Senator Schumer and Congressman Kanjorski that the SEC should be self-funded. As Congress contemplates the Consumer Financial Protection Agency as a self-funded entity, I ask that it apply the same principle to the SEC. Being self-funded would put the SEC on the same financial footing as the FDIC, the Federal Reserve, and other financial regulators.

The details of the exact funding mechanism would need to be worked out and there are several possible options including the SEC retaining the registration and securities transaction fees currently collected. These fees currently go directly to the Treasury and have generally exceeded the SEC’s budget by a significant amount. I have seen some press discussions containing some misconceptions about the possibility of SEC self-funding — particularly the idea that penalties could be used as part of the funding process. I have been clear on this, but let me repeat myself. I would never contemplate penalties collected as a result of the SEC’s enforcement actions as a source of funding. The penalty amounts are best served by being returned to investors or by going straight to the Treasury.

Let me also clear up another misconception. Being self-funded will not mean that the SEC would have unfettered discretion. Like other self-funded agencies, the SEC would still be subject to rigorous oversight by Congress. Moreover, it would still be subject to audits by the Government Accountability Office, and its own Inspector General. Additionally, the Office of Management and Budget, the Office of Personnel Management, and the General Services Administration all would continue to conduct oversight over the SEC’s management practices, in areas such as procurement, information technology, human resources, and financial management. On top of all of this, the SEC would still be required to publish its strategic plan and to chart its progress against specific performance measures.

The issue of funding is also particularly acute because the SEC’s responsibilities may be about to significantly grow. Currently, Congress is contemplating expanding the SEC’s jurisdiction to include hedge fund advisers and over-the-counter derivatives, among others. Taking the hedge fund industry alone, the SEC will need to build staff expertise and increase its staff, as well as make significant investments in technology. Just granting the SEC authority over hedge fund advisers is helpful but without coupling the authority with resources it will not result in sustainable reform. For example, three years ago, Congress legislatively directed the SEC to oversee credit rating agencies. However, this grant of authority was not accompanied by a grant of dedicated rulemaking, investigative, and enforcement staff or funding for technology. Basically, the SEC was asked to do a lot more with the same or less overall resources.

Future reforms are destined to fail if no provision is made to accompany the reform with the resources that the Commission needs to make the reform sustainable.

Conclusion

Regulatory reform is upon us. The hope is that we do it in a smart and effective manner. To that end, I encourage all of you to get involved. After all, you are the ones in the trenches — the ones doing the work and the ones that understand what will — and will not — work. Bring your voices to the debate.

In conclusion, I am confident that regulation of the investment management industry can be done right — in a way that balances the needs of the industry with the needs of investors and the needs of the market. An empowered SEC, appropriately funded and authorized by Congress, is a key participant to establishing a level playing field for investors and market participants alike.

Endnotes

[1] President Barack Obama, Remarks by the President to a Joint Session of Congress on Health Care, September 9, 2009, see http://www.whitehouse.gov/the_press_office/Remarks-by-the-President-to-a-Joint-Session-of-Congress-on-Health-Care.
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[2] Jaretski, Alfred, “The Investment Company Act of 1940,” Washington University Law Quarterly (April 1941) pg. 311.
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The UK is reviewing rules governing its civil justice system, including class actions. Lord Justice Jackson is expected to publish a report in the next few months that will take up a number of proposals, including proposals to abolish the “loser pays” rule in collective lawsuits. Yet US experience – as illustrated by a current case before the US Supreme Court – may provide a useful caution. Jones v. Harris Associates L.P., argued on November 2, 2009, demonstrates that lowering the “loser pays” barrier could have serious consequences.

In the US, of course, each side in a lawsuit – including class actions ­ pays its own costs regardless of outcome, and plaintiff lawyers can often extract a settlement that covers their costs (plus a bit), even if the case would lose at trial. A prime example is Jones v. Harris. In that case, plaintiffs’ attorneys allege a financial adviser breached its duties by overcharging clients of its collective investment schemes (mutual funds) for services. In the trial court, they lost. The adviser, after all, had produced above-average returns over many years in return for fees well within industry norms – and well below typical advisory fees in the UK. But the case has survived two rounds of appeal – despite independent trustees having negotiated the fees on behalf of investors, despite investors having approved the fees, and despite the fact that investors are free to liquidate at net asset value at any time and move their funds elsewhere in a highly competitive market.

How can such cases make it to the highest court in the land? Plaintiffs’ lawyers are able to file these cases because of three features of the US legal system. First, investors are dispersed, and cannot easily work together to protect their own interests. Collective action costs are often identified as a reason that investors cannot protect themselves from predatory institutions – and sometimes that is true. But those same costs also make it impossible for investors to control the lawyers who nominally represent them. Investors cannot stop lawyers from using weak or even frivolous claims to extract rich legal fees. Nor need lawyers even listen to investors with the most at stake in a case. Unlike the advisers, the lawyers are not required to negotiate with independent trustees, or to submit their lawsuit for approval to the investors. Once lawyers have appointed themselves as investor guardians, they face little competition – again, unlike the advisers, who compete with other advisers to attract new investments. Second, relevant US law is vague. A federal statute imposes on advisers an undefined “fiduciary duty with respect to the receipt of compensation”. Without clear or uniform rules to guide courts, without clear direction that judges consider the effects of competition, cases can be brought and slip through the barriers that are supposed to limit frivolous claims and discipline plaintiffs’ lawyers.

In these two respects, the UK and the US are much alike. UK investors (and consumers) are dispersed, and would have no easier time controlling lawyers who nominally represent them in collective actions. UK law is also full of vague standards – including fiduciary duties. That leaves the third element of the US system – the one distinguishing the UK at the moment. In the US, plaintiffs’ lawyers face no deterrent other than their own time and costs – they never need worry about compensating the adviser even if the defendant prevails. Lord Justice Jackson should pause long before giving up that distinction.