Bennett Jones lawyer Usman Sheikh sits down with former SEC Chairman Mary Schapiro to discuss High Frequency Trading and Michael Lewis' Flash Boys, Madoff's Ponzi Scheme, the SEC's No-Admit No-Deny Policy, a Canadian National Securities Regulator and more.
Mary L. Schapiro was the 29th Chairman of the U.S. Securities and Exchange Commission. Chairman Schapiro was appointed by President Barack Obama on January 20, 2009 and served through 2012. She was the first woman to serve as the agency's Chairman and the only person to have served as Chairman of both the SEC and the Commodity Futures Trading Commission. Ms. Schapiro presided over one of the busiest rule-making agenda's in the SEC's history. During her term, the SEC also brought a record number of enforcement actions. Ms. Schapiro currently serves as Vice Chairman of the Advisory Board and Special Adviser to Promontory, a risk management and regulatory compliance consulting firm.
On Accepting the Role of SEC Chairman...
US: First of all, Ms. Shapiro, it is an absolute privilege to meet you.
You took the helm of the SEC at one of its most trying times:
- just a few months before your appointment, Madoff was arrested after the SEC had failed to uncover his massive ponzi scheme;
- the U.S. economy had been dealt a critical blow by the credit crisis and was heading into a deep recession;
- members of the U.S. government were calling for heads, not only from Wall Street but also suggesting that the SEC should be dismantled.
Describe for me the challenges that you were facing taking on your new role as Chairman of the SEC when you did. Why did you decide to take on that task? And what did you see as your biggest challenges at the time?
MS: I took the task on because I had served at the SEC from 1988 to 1994 as a Commissioner and I had great admiration and a deep affection for the agency and its staff.
So when the President asked me to return to the agency as Chairman, that was one of those things that I could not say "no" to.
But, you're right, it was a very difficult time in the agency's history.
Madoff was arrested shortly before I was nominated and the five major investment banks that the SEC had responsibility for had either been sold, failed (like Lehman Brothers) or converted to bank holding companies. It was a difficult time for the agency.
There were a lot of staff vacancies at the senior level, which is typical when an administration changes, and morale was pretty low. Resources were desperately needed for technology and new skill sets were needed to come into the agency.
I didn't fully appreciate all of those things before I arrived but it was pretty quickly clear to me that there was a lot of work to do.
And so, we set about to build a highly expert, a highly collaborative team-oriented senior staff. We brought in great people who shared a vision of one SEC – we all work together, we share information, we support each other to get the job done.
We tried to re-orient the agency towards a more investor-focused agenda in terms of rulemaking; we reorganized and restructured the Enforcement and Examination functions; we responded to the Madoff fraud – taking responsibility for what had gone wrong and laying out a transparent plan for how to fix the issues that allowed the fraud to go undetected for so long (to this day, there is a section of the SEC website called "Post-Madoff Reforms").
The Madoff reforms included everything from some new rules to protect client assets; to training and new skill sets; the whistleblower program; and a tips, complaints and referrals program and associated technology.
We set out also to reorganize the agency in a way that allowed us to be more efficient. So, for example, in the Enforcement Division we took out a layer of management. We organized some of the staff into specialized units so they could become more agile and more expert in particular areas (like the Foreign Corrupt Practices Act or insider trading or municipal securities issues), rather than having people moving all over the place all of the time. And that reorganization, I think, yielded terrific results and remains in place, and, I think, over time, additional specialized units will be added.
Then, we started to engage in the regulatory reform debate, explaining why you cannot be the largest capital market in the world and not have a capital markets regulator, like the SEC, that's well funded and aggressive and highly expert.
So, really I thought I had three jobs in those days: regulatory reform; reorganizing and restructuring the agency; and then getting focused on an agenda of things that were really important to do that had been really on the back burner during the financial crisis because people were stretched so thin.
On The Madoff Ponzi Scheme...
US: Let me ask you about the Madoff scheme. Of course, hindsight is 20/20 but looking back, why do you think the SEC failed to uncover that $65 billion ponzi scheme?
MS: I think it was a combination of things.
I think it was the siloed approach to issues for the agency – people did not communicate well across divisions or across geographies, so the information never really came together in a single place that might have led somebody to actually dig deeper and go further.
It is not at all clear to me that the people who received the information from Harry Markopolos truly understood what they were looking at.
I think there were resource implications – people kept getting moved from project to project and didn't get exams finished.
And I think there was a lack of sufficient skepticism about what the firm was doing and this whole other piece of it that wasn't as visible as the broker-dealer was.
US: What do you think that the SEC and other securities regulators can and perhaps should learn from that experience?
MS: For us, the learnings were pretty clear.
We needed a much more collaborative approach to problems; sharing of information and concerns. We needed much more skepticism in dealing with people even if they were well established and had been around the industry for a long time – perhaps especially because they had.
We needed some rules to bolster the safety of client assets, and we did those. We needed more examiner resources and understanding of trading strategies. I think those are the key take-aways but the skepticism and the "pushing, pushing, pushing" piece of it just wasn't there.
On Securities Enforcement Successes in the United States...
US: After Madoff, your agency (under your leadership) engaged in quite dramatic reforms, which included a complete overhaul of the SEC's enforcement program.
By the end of your tenure, the SEC had brought a record number of enforcement actions, including quite significant cases against those connected with the financial crisis.
We here in Canada, particularly in recent years, have been watching with some amazement as to the quite astronomical penalties that have been obtained in the U.S. by the SEC and other securities authorities (e.g., the penalty of $550 million against Goldman Sachs; $600 million against SAC; and others).
What do you attribute to these successes? In particular, what do you think have been the key regulatory tools that have been instrumental in bringing those cases to a conclusion and getting such large penalties?
MS: Well, I think the SEC has a tremendously talented Enforcement Division and people who are absolutely committed to pursuing the evidence and bringing the strongest, broadest case that they possibly can.
All the credit really goes to the staff – for sure.
I think coming out of the crisis it was important that we develop expertise with respect to some of the more complex products that were at the heart of the crisis. We brought in people who had lived in that world and understood it and that was really helpful to working our way through millions of pages of documents and being able to take testimony credibly.
I think that those new skill sets for the agency were enormously important.
The SEC will always have a lot of lawyers and accountants, and we love our lawyers and accountants, but then it is also useful to get traders or quants, or people who have worked at credit rating agencies, and people who have been in investment banks and in hedge funds onto staff to help with some of these more cutting edge cases.
On the SEC's No-Admit No-Deny Policy...
US: Let me now ask you about the SEC's no-admit no-deny policy.
One regulatory initiative that has just been adopted by the OSC here in Ontario (last month, in fact) is to allow their staff to engage in what are termed "no contest" settlements (essentially, settlements without admissions) with respondents in quite limited circumstances. The stated purpose is to increase the effectiveness of enforcement.
Obviously, the SEC has had a long-standing policy of allowing no-admit no-deny settlements, with a recent policy shift of requiring admissions in certain circumstances. We're having Judge Rakoff speak to our members next month on this topic.
MS: I like Jed Rakoff very much. I know him and I respect him enormously.
US: What can you tell us of the importance of these no contest settlements based on the U.S. experience?
MS: It's obviously been controversial in the U.S., recently at least.
But the SEC has had a practice for decades, as has virtually every other federal regulatory agency that has an enforcement program (the Federal Trade Commission, the CFTC, even the DOJ on the civil side) of allowing parties to settle without admitting or denying the allegations.
In fact, for the SEC, it's neither admit nor deny. Some agencies actually (like the Federal Trade Commission) allow respondents or defendants to deny. They actually will say in the settlement document: "we do not admit to the facts or the allegations; in fact, we deny them except as to the jurisdiction of the FTC' – but the reality is that the SEC, which does not permit denial, actually already had a tighter standard than the other federal agencies.
And so here's the reason for the policy and here's my personal view about it.
I understand the desire for accountability. I understand the desire for admissions. I share that desire.
But if the SEC can bring a case and can get, in a settlement, basically what it would get in litigation without the risk of losing; getting to resolution much faster; and get money back to investors much more quickly; and issue a complaint that lays out all of the misconduct, so that the public and industry are on notice and are aware, then that's a pretty good deal, because it conserves our resources to go after the next case and the next case and the next case. Because there will always be more. And conserving resources in order to have the broadest possible impact is really important for a federal agency.
Now, if you couldn't settle the case for something akin to what you'd get in court if you won then you wouldn't settle and it would be inappropriate to settle.
But our view was if we can get about the same thing and not have the uncertainty of possibly losing in court, that was worth doing.
We made two changes while I was there. One is if there were parallel criminal proceedings or parallel civil proceedings where there was an admission or finding, you couldn't do neither admit nor deny – you had to admit in our settlement.
And in the Goldman Sachs case that you mentioned we actually required them to admit to the inadequacy of their disclosures. So we started to open the door.
My successor, Mary Jo White, took the next step and said, in some cases, where there is egregious harm to investors or recidivist conduct, we will get an admission or we won't settle. It's not all cases by any means – I think they've done half a dozen in the last year. So the vast majority of cases still settle on a neither admit nor deny basis.
And if you look at what they admit to – sometimes it's less than admitting to the core fraud – so it's nuanced even to this day.
That said, I applaud the direction. I think it's the right thing to do.
I think the issue is – and the agency will have to watch this carefully – whether people will still settle, because if the agency has to litigate every case, the resources are not there to do nearly as many cases as the agency has done historically. The staff has the talent but they don't have the numbers to litigate every case; and, you're going to lose some cases.
You've then forgone the possibility of getting money back to investors at all or, in some cases, quickly because cases take years to get through the litigation pipeline, particularly in the Federal District Court.
So it's an issue that I understand very much – the desire for accountability and the desire for admissions and I share that, but it's not that black and white of an issue. There are trade-offs to seeking admissions, and they may well be worth it in some cases – absolutely will be worth it in some cases – but I think we need to see, on balance, what it does to the program.
On High Frequency Trading and Michael Lewis' Flash Boys...
US: Let me switch to another topic, if I may.
I wanted to ask you about Michael Lewis' latest book, Flash Boys. It was only published a short while ago but this book has effectively set off a complete firestorm of controversy over the practice of high frequency trading.
Some critics are saying that such trading is effectively scalping; and Charles Swabb recently referred to as a "growing cancer" on the market.
Its supporters say that such trading has made significant improvements to the market, including greater liquidity, more efficient pricing and lower costs of trading.
The New York Attorney General and the U.S. Department of Justice have recently either announced or confirmed investigations into high frequency trading – including, front running, insider trading and latency arbitrage issues.
Generally speaking, where do you fall in this debate? What are your views on the practice of high frequency trading?
MS: Look, it's also quite nuanced.
The SEC has investigations ongoing. And the economic research / academic research is all over the place on whether algorithmic trading or high frequency trading is a benefit or a detriment to the quality of our markets.
So I think the first step is really to try to get some more definitive answers about what is happening to market quality from high frequency trading and from particular strategies that may be engaged in. So that work is ongoing.
When I was SEC Chairman, we contracted to receive massive amounts of data (actually from a high frequency trading firm) to allow the staff to do analysis and that data is now being made public on the SEC website.
So, we have to take that data-driven approach, for sure.
But the reality is, if investors think the market isn't fair, they won't have confidence in it. The reality of course matters but how people perceive the fairness of the market also matters hugely –and investor confidence is really the pillar of markets operating effectively.
And, so, we have to deal with this perception/reality (because it could be both) that high frequency trading is disadvantaging regular investors because potentially HFTs get access to data feeds faster or they colocate or they utilize dark pools or they have special order types or any number of other issues. We need to give investors a clear picture of what's going on.
US: Mr. Lewis specifically claims that your markets are rigged. As the former head of the SEC, CFTC and FINRA, how do you respond to that claim?
MS: I don't think the markets are rigged.
That said I think there are issues within our market structure including around high frequency trading and dark pools (as two examples) that really do need to be addressed. Coming out of the Flash Crash in May 2010, which was an algorithmic trading problem (we and the CFTC concluded that high-frequency trading didn't cause it but certainly contributed to it particularly when they withdrew from the market and the liquidity disappeared) and so we put several provisions in place to try to prevent a Flash Crash from happening again but knowing that we needed to take this much deeper dive into many more basics of market structure.
And then Dodd Frank came along and it got very hard to do anything but Dodd Frank, but I think the agency is re-engaging on that now.
On Future Threats to the Capital Market...
US: What do you see as the next upcoming threats to our capital markets? What are the greatest challenges that you foresee for securities regulators?
MS: I think there are a few things.
For the U.S. regulators, the adequacy of resources to do the job that they've been given to do is a huge issue, and I suspect it's an issue around the world.
After the financial crisis, we have demanded more and more of our regulators.
In the U.S., for example, the SEC and the CFTC were given responsibility for hundreds of trillions of dollars of swap and OTC derivative market trading and very little in additional resources with which to handle that responsibility. The SEC was given responsibility for hedge funds, but very little additional resources to handle that responsibility.
If we're going to rely on regulators, as much as the legislation introduced around the world has suggested we are, then we need to fund them adequately to do the job. Otherwise, we have just created a whole new moral hazard by saying that "well, the rules are all in place and the regulators are on top of it, so don't worry" when, in fact, they are not on top of it because they don't have the resources.
If you look at an agency like the CFTC, which was given the lion's share of the over the counter derivatives markets – it is a $600 trillion market – the CFTC has actually had its budget cut in the last several years. They have between 600 - 700 people at the CFTC; about a $250 million budget to handle the entire regulated futures market and now the over the counter derivatives market.
That's a problem waiting to happen – for sure. So I think that's a big worry.
The other worry I have – and I've been saying this for months – Congress was wise and we did the right thing in moving derivatives into clearinghouses with central counterparties to reduce counterparty credit risk, increasing transparency, requiring exchange trading, imposing business conduct standards and standards on clearing agencies – those are all great things – but if there are no resources to oversee these clearinghouses where we have now concentrated extraordinary amounts of risk and if the capital requirements and the risk management and the stress tests of those entities isn't really robust, that's something I think regulators need to be really focused on. Clearinghouses are right in the center, more than ever before, of the financial system.
On A Canadian National Securities Regulator...
US: To deal with these and other threats, we have seen and will be seeing a much greater and significant amount of interaction and cooperation among regulators, particularly between the U.S. and Canada.
There's currently a very big debate in our country and a big push to develop a national securities regulator.
What can you tell us of your experience while serving as Chairman of the SEC dealing with Canada, a country with 13 different securities regulators? How do you think that those dealings would change if Canada were to move to a single national regulator?
MS: We have a pretty fragmented regulatory system in the U.S. too.
We have two capital markets regulators; we have four banking regulators; we have 50 state insurance, 50 state banking and 50 state securities regulators; we have two housing finance regulators – so we have a pretty fragmented regulatory system too.
There's absolutely costs. There are benefits (different perspectives, different understandings; that's useful in tackling a problem) but it also creates a lot of additional work to coordinate and work together.
Getting the Volcker Rule done is a great example of that – it took three years because of the complexity and need for coordination and cooperation.
So, I have a lot of sympathy for the amount of effort it takes to actually try to level the playing field and work with your fellow regulators when you may have different perspectives.
That said, the U.S. SEC and the Ontario Securities Commission have always had a really superb relationship. It's highly cooperative. It's very collegial.
I would say that Howard Wetston is probably the non-U.S. regulator I spoke to most during my time as Chairman of the SEC. We obviously have interests because of proximity, but I also just found him and his team to be very thoughtful and it's been a great relationship.
US: Ms. Schapiro, I want to thank you for your time.
MS: You're welcome.
Usman M. Sheikh serves as Vice-Chair of The Advocates' Society Securities Litigation Practice Group. He is a corporate / securities litigator at Bennett Jones LLP. The views expressed in this article are his own.
Originally published on the Securities Litigation Blog of the Advocates' Society.
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