Hensarling presses Clayton on easing capital formation rules to encourage IPOs; Waters questions Chairman on SEC's proposed 'regulation best interest' for brokers

The House Financial Services Committee on June 21, 2018, held a hearing on "Oversight of the Securities and Exchange Commission." The only witness was SEC Chairman Jay Clayton. Materials from the hearing are posted here.

In his statement, committee Chairman Jeb Hensarling (R-TX) said he was grateful that Clayton has devoted more time and attention to the capital formation part of the SEC's mission. He said the economy has shown "worrisome signs" such as a 40-year low (in 2016) for entrepreneurial start-ups and the "downward slide" of IPOs. "How can we sustain long-term 3% GDP growth without ensuring that we have plenty of these startups in the pipeline? … How will we successfully compete with China … unless we infuse more reforms into our capital markets?" Hensarling continued, "How can Main Street investors have more opportunities to invest in their futures? How can they invest in great companies when we look at our IPO market and see that so many of our public companies are now older, they're bigger, they're fewer? … Why was it only the wealthy that managed to invest in these companies on the way up, and not our teachers, our barbers, our farmers, and our first responders?" Hensarling said the committee has "an opportunity [to act], since we know the Senate will be voting on a package of capital formation bills. Historically, this is something that has been done on a bipartisan basis in this Committee."

In her statement, Ranking Member Maxine Waters (D-CA) said she was concerned about the re-proposal of the Dodd-Frank Volcker Rule, which bans banks from proprietary trading for their own accounts, that was rolled out by several financial regulators a few weeks ago. Waters said the SEC's analysis of the new proposal said it "could increase moral hazard risks related to proprietary trading by allowing dealers to take positions that are economically equivalent to positions they could have taken in the absence of the 2013 final rule." Waters said she was wondering why the SEC would support changes that would increase such risks. Waters said she is also concerned about the SEC's proposed Regulation Best Interest for brokers, urging Clayton to ensure that the final rule will protect investors and retirement savers from unscrupulous actors. Turning to Hensarling's plan to advance a package of capital markets bills, Waters said, "I have not been consulted on what might be included in such a package, but based on some of the bills the Committee has marked up to date, I remain concerned that this package may contain bills that could weaken investor protections."

In his statement, SEC Chairman Jay Clayton said the SEC recently published a multi-year strategic plan that will establish a framework for the agency's future. Its key priorities include "1) our commitment to Main Street investors; 2) a focus on being innovative, responsive and resilient to developments and trends in the markets; and 3) using technology, data analytics and human capital to improve our performance and manage our internal resources and risks." In the area of capital formation, Clayton said the SEC's Division of Corporation Finance has carried out several key initiatives with a particular emphasis on capital-raising opportunities, expanding the confidential submission process, providing greater clarity about what financial information is required when submitting draft registration statements, and encouraging companies to approach the SEC staff about impediments to raising capital and pursuing novel transactions. Clayton said he expects the SEC "will soon consider adopting final amendments to the 'smaller reporting company' definition, which would expand the number of issuers eligible to provide scaled disclosures." The SEC is also "taking a fresh look at the thresholds that trigger the requirement contained in Section 404(b) of Sarbanes-Oxley to have an auditor provide an attestation report on internal control over financial reporting."

Turning to the proxy process for shareholders, Clayton said the SEC is reviewing several proxy issues, including "the quality and mix of information provided to shareholders and how that information is provided; shareholder proposals; the role of proxy advisory firms; and the costs and burdens of the proxy system on companies and shareholders." Clayton's 25-page prepared statement had a long discussion of cybersecurity issues, and also touched on: the Commission's April action proposing Regulation Best Interest for broker dealers; digital assets and initial coin offerings (ICOs); enforcement; examination priorities; equity market structure; fixed income market structure; the consolidated audit trail (CAT); security-based swaps; modernizing asset management rules; and the status of remaining Dodd-Frank rulemaking.

Questions

Chairman Hensarling again mentioned the 20-year decline in IPOs, and asked how big the problem was, and "what opportunities Main Street investors are losing out on." Clayton said he believes the U.S. is impeding capital formation, and he is troubled that the "suite of opportunities" available to investors is shrinking along with the size of the capital markets generally. Hensarling noted that Clayton had said the SEC will hold a meeting on Thursday, June 28, that will deal with reporting obligations faced by smaller companies. He asked if the meeting will deal with Sarbanes-Oxley 404(b) issues. Clayton said yes, he expected that meeting will deal with those "thresholds" for smaller companies. Hensarling commended Clayton for addressing this "on-ramp" issue and pointed out that a Treasury report last year had offered 15 policy recommendations in this area. The chairman then asked what the SEC is "contemplating at the moment" on guidance for angel investors and the definition of an accredited investor. Clayton said the Commission is "looking at the path provided by the JOBS Act" for providing "scaled" disclosures and other requirements, and also looking at the definition of accredited investors, which he believes should be modernized.

Ranking Member Waters reiterated concerns expressed in her opening statement about whether the SEC's proposal for a best interest standard for brokers "does apply a fiduciary standard to brokers that effectively function as investment advisers … The best way to protect investors and reduce confusion is to treat all advisers, regardless of their titles, the same under a fiduciary standard that requires them to put their clients' interests first." But she said the SEC's proposal would only prohibit brokers from calling themselves advisers, "and fails to address the numerous other titles that may be used, like financial planner or wealth manager." She said it would be "far simpler and clearer for investors to subject any broker who holds himself out as offering investment advice or engaging in advisory services to the Advisers Act's fiduciary duty." Clayton outlined the differences between the two "relationship models" for serving retail investors — investment adviser and broker dealer. "What we are doing, in each case, I can't put my interests ahead of yours. We are bringing to the broker dealer space that requirement. We're also bringing … care obligations, so that in getting to the stocks I will recommend to you, I have to go through a series of steps to ensure those are right for you and your circumstances." He said the proposed new Form CRS (Client Relationship Summary) will help investors understand "what the broker is doing, how they are being paid and what their other incentives are." Clayton said "there is no conflict-free relationship … disclosing them, mitigating them, making sure everybody understands what the motivations are — that's what I want to do in this space."

Bill Huizenga (R-MI) said that today's capital markets are "digital and fast-paced" while their regulations are "analog, paper-based … We need to catch up." He thanked Clayton for proposing the "loan rule" for auditing firms on May 2, which addresses situations where a company's auditor has a lending relationship with certain shareholders and people associated with an audit client. (The proposal limits the rule's scope to the beneficial owners of the client's securities). Huizenga called the loan rule a longtime source of uncertainty in the markets. Huizenga also addressed the Supreme Court's Kokesh ruling, which, according to testimony by SEC enforcement officials a few weeks ago, has prevented the SEC from disgorging $800 million in fines from companies. He asked what Clayton thought Congress should be considering as it looks to remedy the Kokesh decision, such as extending the statute of limitations. Clayton said he thought statutes of limitations serve an important role, but "the most well-concealed frauds fall outside of that limitations period." He said a possible way to address the ruling is "to give us restitution authority in those circumstances."

Carolyn Maloney (D-NY) noted that she had previously asked Clayton if the SEC's pilot program on access fees charged by exchanges was going to include a zero-rebate bucket. She asked when Clayton expects to finalize the access-fee program. Clayton said the public comment period for the program is ending soon: "It is on my near-term agenda … I would say sometime this fall." Maloney then asked about "a very troubling meeting" that SEC Commissioner Michael Piwowar had with Citigroup, which has announced a policy in which the bank will require all the retailers that it does business with to adopt certain best practices on gun sales. Piwowar reportedly "castigated" the Citi executives for "straying into social policy" and issued "a thinly veiled threat," saying the company's gun policy would cause them to lose votes on certain SEC rules. Clayton said he would not comment on the press reports of Piwowar's meeting. He said that at a previous Senate hearing, the question of an Inspector General's inquiry into this issue had come up and he would cooperate with any such investigation. Ruben Kihuen (D-NV) also raised this issue toward the end of the hearing.

Ann Wagner (R-MO) asked if the SEC has started the process of investor testing for its proposed Regulation Best Interest for brokers, and if its results will be made public. Clayton said the Commission's Investor Advocate Office had begun the testing process, while the SEC has been holding a series of six field hearings to gather feedback on the proposal; he expected the investor testing results to be "publicly available in some form." He told Wagner that he did not believe the SEC will need to extend the 90-day comment period.

Brad Sherman (D-CA) commended the SEC for moving forward with its changes to Rule 30e-3, allowing mutual funds to deliver reports in electronic form. Sherman said the rule would save $2 billion in paper printing costs. He asked what more the Commission can do in terms of electronic delivery. Clayton said Rule 30e-3 "was a big step — I think we landed in a good spot, but it's just a start. Modernizing our rules here is front-of-mind for our Division of Investment Management." He said that on Thursday June 28, the SEC will vote on a rule related to inclusion of the XBRL reporting language. Sherman then urged Clayton to update the SEC's definition of accredited investors. Clayton told him that such investors "have to be capable of handling the private investment arena … This is a complicated issue."

Andy Barr (R-KY) asked about short-selling issues, saying he didn't share the view that "stealth" short positions are necessarily bad, and that many people believe that short-sellers provide "a heterogeneity of views" and boost the market's efficiency. Barr said that while some critics have proposed a disclosure regime for short-sellers, others believe that would discourage institutional investors from taking short positions. Clayton said he didn't have "a definitive view on a particular rule or not: "There are valid points in those arguments. If we can get at the behavior that causes the stock's price to depart from its quoted value, that's how we should look at it." Barr also asked about the status of the SEC's effort to implement a Dodd-Frank rule on disclosures by mining companies; Clayton said this was on their short-term agenda, i.e., they hope to finish it by the end of the fiscal year.

Gregory Meeks (D-NY) asked about disclosures for dual-class stock structures, which he said are common among "tech giants" like Facebook. Meeks said such structures "can create a system where average investors have less power to hold CEOs and directors accountable." Clayton said the SEC's Investor Advisory Committee had issued recommendations clarifying "the disclosures around governance, and what these structures mean to governance … I 100% agree that the disclosure needs to be clear and accessible." He said that while shareholders typically expect one vote for one share, "on a supervote stock, that dilutes your rights as a shareholder … you should be able to know that from the disclosure …. If you take a dual-class structure to the extreme, someone could have complete voting dominance in a stock but otherwise have no stake in the game."

Randy Hultgren (R-IL) said CFTC Chairman Chris Giancarlo had recently testified that "during the recent market volatility, the supplemental leverage ratio impacted larger market-makers' ability to take certain market positions, thus exacerbating the volatility. The SLR is not specified in Dodd-Frank and has had the opposite effect that was intended, pushing trades away from central clearing." Clayton told him that participants who provide liquidity in the cash market use the options market as part of their business, "and to the extent that liquidity dries up in the options market, it can cause a knock-on effect in the cash market. I know my fellow federal financial regulators are aware of this issue."

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