The Securities and Exchange Commission, according to testimony by its chairwoman, Mary Jo White, is desperately short of resources and cannot adequately fulfill its responsibility to oversee the capital markets.
The SEC's difficulties should remind asset owners to reassess whether the financial resources they dedicate to due diligence of investment advisory firms and other investment-related service providers are sufficient to address the increasing demands for due diligence.
SEC examinations cannot substitute for an asset owner's own due diligence. But the SEC can bring to bear potentially more resources and more clout, and focus on a wider range of issues, from an inspection of a single investment advisory firm to weakness in the stability of the marketwide trading structure. An SEC inspection can complement due diligence processes undertaken by asset owners, uncovering issues that are elusive, or risks that can be systemic, threatening the stability of the markets.
The insufficiency of SEC inspections exposes fiduciaries to more risk, especially as investment management firm structures and investment products become more complex.
Fiduciaries should raise their voices to express their concern about the shortfall in SEC funding, and the need for Congress to increase it. Asset owners, along with investment advisory firms, should do their part and call for an increase in user fees, especially at the institutional level, to contribute to SEC financing. They have the most exposure and would benefit the most.
Ms. White drew attention to the inadequacy of SEC resources in testifying Sept. 9 before the Senate Committee on Banking, Housing and Urban Affairs.
Since the fiscal year ended Sept. 30, 2012, “the SEC has not received a significant increase in resources to permit the agency to bring on the additional staff needed to adequately carry out our mission,” Ms. White's prepared remarks said.
“While the SEC makes increasingly effective and efficient use of its limited resources, we nevertheless were in a position to only examine 9% of registered investment advisers in fiscal year 2013,” she said. “In 2004, the SEC had 19 examiners per trillion dollars in investment adviser assets under management. Today, we have only eight.”
In testimony before the Senate Subcommittee on Financial Services and General Government, Committee on Appropriations last year, Ms. White pointed out more than 40% of investment advisory firms have never been examined by the SEC.
At the hearing this month, Ms. White said, “Additional resources are vital to increase exam coverage over investment advisers and other key areas, and also to bolster our core investigative, litigation and analytical enforcement functions.”
The new ruling-making and enforcement oversight called for in the Dodd-Frank Wall Street Reform and Consumer Protection Act and the Jumpstart Our Business Startups Act added to SEC oversight responsibilities.
The Dodd-Frank act required SEC registration of hedge fund and private equity managers that had previously been exempt from the regulation.
But even without those additional regulatory responsibilities, “our significant budgetary gap and needs would remain,” Ms. White said during the hearing this month.
Investors have to have confidence in the integrity of the capital markets and investment advisory firms and other investment-related service providers. The SEC can help bolster that confidence by stepping up examinations, which can lead to enforcement actions, warnings or correctives, all to the benefit of investors.
More resources alone won't guarantee strong SEC oversight and enforcement. The SEC failed to investigate allegations that Bernard Madoff was overseeing a Ponzi scheme. The agency let it go uncovered for years after the accusation was first brought to its attention in 1992, bringing charges against him only in 2008 when the fraud was uncovered, costing investors billions of dollars in losses in the intervening time.
That failure was an issue of leadership, and correcting the SEC's lack of resources won't correct that deficiency.
Such failure should trigger the need for asset owners and their consultants, some misled by Madoff or other investment frauds in recent years, to step up due diligence.
Asset owners face investing in markets that are more complex than ever. That increased complexity includes trading in markets that are more diffuse and often less transparent, and traders who are more aggressive in competing for trades as exemplified in high-frequency trading. All these developments can benefit asset owners, or add to their costs, or both. They require constant attention. The SEC can bring to bear more data-rich resources than asset owners to analyze weaknesses in those trading markets and provide guidance to asset owners and managers.
Investment management structures also have become more complex, fueled especially by the increased allocations to alternative investments, such as hedge funds and private equity. Investments, fee structures and liquidity terms have become more complex.
Asset owners must ensure they are devoting sufficient resources to evaluating their investment-related providers and prospects, but as good they might be, they cannot supervise the entire market. With that recognition and a willingness to step up to raise their own SEC-related fees, they would have a good case to make to Congress to raise the SEC's budget. n