Monday, September 16, 2013

Congressmen Ask the SEC Why It’s Enforcing the Law

Congressmen Ask the SEC Why It’s Enforcing the Law

Last week a letter from two Congressmen to SEC Chairwoman Mary Jo White drew my attention because they were, in essence, suggesting that SEC should not be enforcing the law.[1]  House Financial Services Committee Chairman Jeb Hensarling (R-TX) and Capital Markets Subcommittee Chairman Scott Garrett (R-NJ) complained that the SEC’s examination of private equity managers was both onerous and unnecessary and asked Ms. Shapiro to respond to their concerns.  Title IV of the Dodd–Frank Wall Street Reform and Consumer Protection Act requires the SEC to provide oversight of private equity funds.  In other words, Chairmen Hensarling and Garrett were asking the SEC to explain why it is following the law.  It’s this kind of inanity that should make Chairwoman White yearn for the relative sanity of private legal practice.
General Presentation (1997)
Not only is the premise of the letter flawed, the logic is weak.  The Chairmen opine that oversight of private equity isn’t required, because PE does not pose systemic risk to the financial system.  As Dodd-Frank acknowledges in Titles I and VIII, certain institutions pose systemic risk to the financial system and should be subject to increased scrutiny, higher capital requirements, and special procedures to ensure an orderly wind down in the event of a failure.  However, neither Dodd-Frank nor any other law suggests that all other institutions should be exempt from oversight because they don’t pose systemic risk to the financial system.  Banks and money managers can do plenty of damage short of destroying our economy and should be regulated.  Moreover, under the law before Dodd-Frank all sorts of conventional money managers and mutual funds were subjected to SEC examination, and none of them pose a systemic risk.

If you don’t buy the Chairmen’s first argument, they have a second line of attack.  They argue that private equity investors are “sophisticated”, and therefore PE firms shouldn’t be subject to SEC oversight.  There are at least three huge holes in this logic.  First, many conventional stock and bond managers only manage accounts for “sophisticated” investors, and they have always been subject to SEC regulation.  Without SEC regulation, sophisticated investors would have a devil of a time wrestling necessary information from money managers.

Second, the definition of “sophisticated” investor under our securities laws is highly questionable.  The law requires a “sophisticated” investor to have “sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.”[2]  The reality is that many institutional investors don’t meet this test, and yet they routinely invest in all sorts of esoteric securities.  One of the reasons that we went off the credit cliff is that many so-called “sophisticated” investors acquired mortgage-back securities without properly understanding the risks.

Third, the Chairmen conveniently omit the other group of investors who are allowed to invest in PE, hedge funds, and other non-liquid investments: accredited investors.  An accredited investor is someone with an average net worth over a four-year period of $1 million, excluding their principal residence.  Being an accredited investor simply means that the individual may have enough money to avoid being destitute if a PE investment goes sour.  Many folks with a million net worth don’t have the knowledge or means of evaluating PE firms or for that matter far more straightforward investments.  I receive email from these types of folks all the time.

Having been subject to numerous SEC examinations over my career, I agree with the  House Chairmen that they can be a pain in the neck.  However, Dodd-Frank makes the burden extremely manageable.  The law exempts venture capital firms (I’m not sure why) as well as any firm with less than $150 million in assets under management.  In other words, the firms subject to SEC examination have at least $2 to $3 million in revenues from management fees alone, and thus have more than enough money to comply with the SEC’s requirements.

It’s not hard to understand why the Chairmen wrote this letter.  You need only go to and peruse their campaign contributions.  It seems to me the financial services industry, and private equity in particular, has enough money to do its own lobbying at the SEC without the aid of Mssrs. Hensarling and Garrett.  Both Representatives spend a lot of time on their House websites talking about upholding the law and the constitution when it comes to their favorite issues.  However, when their focus turns to our financial system, they’d prefer that our regulatory agencies not enforce the law.


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