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Securities and Exchange Commission Investor Advisory Committee Meeting

Securities and Exchange Commission (SEC)

Investor Advisory Committee Meeting

Thursday, July 25, 2019

Discussion Panels

Opening Statements

Chairman Jay Clayton

Clayton said the Investor Advisory Committee (IAC) discussion on promoting competition is important for examining the functions of capital markets. He continued that the SEC led efforts in the past to eliminate opacity, which led to more transparent and competitive trading, and that this should be the approach for the National Market System (NMS) system, adding the need to review and enforce violations of regulation breaches which stifles competition. He noted that transparency leads to lower market fees, clear choice, and increased competition, and the SEC would continue to work with other regulators to implement rules that incentive these policies. Clayton added that he is interested in improving the proxy advisor voting process and the impact Markets in Financial Instruments Directive (MiFID) II has on asset manager and broker-dealer data production and payments. Clayton said that he would like the panel to craft proxy voting policies that are in the best interest of shareholders and are not so cumbersome. He continued that he would like the SEC to act in the near term regarding the conflicts of MiFID in the U.S. system, as the analysis is often static and there are changes over time in markets. He said the dissemination of information is virtually costly and recommended to consider amending rules backward and forward.

Commissioner Robert J. Jackson Jr.

Jackson stated that the issues being discussed in the IAC are “enormously” complex and that there is no easy answer to resolve appropriate market competition, recommending that the panel analyze a few specific areas in need of improvement, rather than the entire broad overview of markets, to benefits investors.

Commissioner Allison Herren Lee

Lee echoed many of the same points as Clayton and Jackson and expressed her interest in the panel addressing the effects of MiFID II on transparency and investor choice, as well as the impact on the quality and quantity of research. She noted the need to address the concern over universal proxy ballots and equal voting rights.

Panel I: Discussion of Regulation in Areas with Limited Competition

Panel Presentation

Aline Darbellay, Assistant Professor of Law, Center for Banking and Financial Law, University of Geneva, Switzerland, stated that since 1970, regulatory barriers to entry have increased core credit rated agencies and led to a lack of coemption in the industry, while the international demand for the financial architecture of credit ratings has elevated. She suggested the SEC consider addressing regulatory oversight, to reduce over-reliance and liability provisions, to address the level of competition. Darbellay said that competition improves financial stability, and often there are tradeoffs between regulation and coemption, as seen in the U.S. through the Dodd-Frank Act. She added that MiFID II has impacted the demand of credit rating agencies for access to market research, especially for U.S. agencies wanting access to European research. She further recommended regulating and supervising credit agencies based on their market share and level the playing field between small and larger agencies. Darbellay suggested considering the impacts of reducing bank and insurance company capital requirements.

Daniel M. Gray, Senior Special Counsel, Office of Market Supervision, Division of Trading and Markets, SEC, suggested considering the impacts of competition of property exchange markets and the flow of market data between firms, as well as the impact on data dissemination and how they influence algorithmic patterns for exchange operations. Gray said that under the Securities and Exchange Act of 1934, exchanges are subject to a complex regulatory regime where they are required to submit numerous filings and pay market fees. He said that Congress facilitated fair competition between exchanges and non-exchanges, which led to the New York Stock Exchange (NYSE) and NASDAQ dominating the stock listing exchanges until the 2000s. He said there are now 13 different exchanges, over 30 alternative trading systems (ATS’s), and broker-dealers who compete in the flow of market data. Gray added that the market-based approach on fees focused on whether fees should continue to be permissible based on the level of competition they incentivize. He explained that this led to disputes over what constitutes an adequate level of competition and a court case between SIFMA and the NASDAQ and NYSEC, which is currently in the U.S. Court of Appeals. Gray said this case led over 400 different challenges to administering exchange fees, adding that the SEC held a roundtable on the topic of sufficient competition levels for reasonable fees. He said that the exchanges maintain the position that the level of competition of flow is disciplined and a shift in prices would “dramatically” affect the market. Gray suggested the consideration of exploring a revenue cap or adopting a market data fees-based model.

Robert H. Lande, Venable Professor of Law, University of Baltimore School of Law, stated that there are concerns of antitrust to consider in the markets, specifically regarding collusion, which harms competition and consumers. He stated there are three fundamental types of anticompetitive collusion: 1) classic collusion, which is when firms act as a monopoly by reducing their output to increase prices; 2) disadvantaging rivals by targeting and weakening them through the collusion of revenue and cost reduction, which leads to long-term price increases and is most commonly done through methods of a boycott; and 3) the most obscure type, fixing the rules of competition, which is when cartels limit the shape of competition to benefit hard competition by exploiting the “cushion” they find in restrictions and isolating coemption. Lande said collusion needs to be addressed based on ethical rules of conduct, how it leads to anti-competitiveness, and how it impacts traditional areas.

Narahari Phatak, Associate Director for Policy Economics, Division of Economic and Risk Analysis, SEC, said the SEC engages in a “rigorous” economic risk-based analysis for all rules filed and has to consider how the proposed regulations affect capital formation and competition. He said that as firms are competing to provide lower costs, there are adverse effects to conceptions and barriers to entry and exit, which the SEC must consider. Phatak suggested considering the costs of regulatory intervention, mainly because there is no such thing as a “free lunch” in a competitive market. He said that analysis should focus on the intensity of market share and management of risk, as well as the impact of compliance costs. Phatak said the SEC is committed to the policy goal of improving transparency and coemption.

Craig Pirrong, Professor of Finance, Bauer College of Business, University of Houston, said the SEC has taken sustainable steps to increase competition through the elimination of opacity and fixed commission through Reg NMS, adding that this has helped fragment the market and reduce barriers to entry. However, Pirrong noted that with regulations there have been unintended consequences for market data competition. He said the SEC and IAC should consider how to regulate specific aspects of the market and how those regulations affect coemption. Pirrong stated that Reg NMS addressed the order of flow and concentration for exchange data but suggested addressing how particulars have affected specific areas of competition and concentration. He said the Dodd-Frank Act has shown that concentrations of markets, with regulations for one objective, can lead to unintended consequences, recommending that regulators consider policies that reduce the barriers to entry.

Question & Answer

John Coates, IAC member, asked about addressing concerns of antitrust in terms of bundling or harmful regulation. Pirrong said that the SEC needs to utilize the economic framework and tools it currently has in place and consider a cost-benefit analysis to address the issue of unintended consequences.

Coates then asked about addressing specific market definitions, to which Lande said that antitrust has to be considered for price changes and the substitute effect, as well as the need to quantify and define markets.

Mina Nguyen, IAC member, asked if there is a residual effect from a cap of data fees. Gray said that European regulators have been struggling with this issue and that the SEC needs more evidence to make a balanced decision on what is an adequate level of coemption to administer exchange fees. Pirrong said exchanges do not have fixed costs of operations and should consider what the correct tools and mechanisms should be to address those fixed costs most efficiently, adding that more market data might be the only way to address the concerns of fixed costs.

J.W. Verret, IAC member, asked about the consolidation of credit rating agencies in the market, and Chairman Clayton asked why there is over-reliance on the credit rating market. Darbellay noted the need to reduce the barriers to entry, increase the quality of market data, and for market share gains.

Barbara Roper, IAC member, asked about the role the SEC could play in promoting competition in markets and investors. Pirrong said high-powered incentives could be “determinantal” and “destructive” at times, and there is a need to frequently move away from them and look at incentives for quality. Lande said there could not be a market reliant on just the range of options or internal choice and protections, noting there is a need for both internal and external protections.

Lydia Mashburn, IAC Member, asked about the lack of competition in the proxy system. Pirrong said currently the U.S. faces a “race to the bottom” in terms of price and quality, and consolidation of the scale of information intensively impacts the securities market.

Jennifer Marietta-Westberg and Lisa Fairfax, IAC members, asked about fixed costs of data and the adequacy of available data. Pirrong said it depends on different sectors of the economy, some of which need more data to structure rules to avoid unintended consequences properly. Phatak said data helps the SEC influence change and identify the impact those rules have while limiting bias. Lande said that data helps regulators account for long-term effects in their forecasts.

Mashburn and Coates asked how the SEC economic analysis process occurs. Phatak said that the economists do not “operate in a vacuum” and they engage in wholesome discussions. He added that they engage in intensive decisions on economic justifications and consider regulatory alternatives in the best interest of competition and capital formation. Gray said there are always people coming into the SEC to discuss the effects rules have on aspects of the markets, which help the commissioners in further discussions.

Panel II: Discussion of Trends in Investment Research and the Impact of MiFID II

Heidi Stam, IAC member, suggested the proposal be amended to address how broker-dealers impact the cost of these services in the process, along with language included about asset managers. She also suggested the SEC tailor appropriate proposals for all market participants. Matthew Furman, IAC member, responded by proposing the adoption of an amendment for language to include that broker-dealers provide greater transparency to research costs and to provide adequate protection for investors.

Barbara Roper, IAC member, enthusiastically supported the recommendation. She added that the committee should consider the impacts of bundled research, the impact on investor choice, and how transparency affects accountability and conduct for market participants.

John Coates, IAC member, suggested that the proposal should have identified the economic impacts of allocation costs from research and how those costs and research impacted end users. He recommended the SEC look into how Asia or Europe regulations impact U.S. firms’ decision making.

Lydia Mashburn, IAC member, said it is important to provide investors with choice without increasing costs on broker-dealers and adding regulatory barriers that prevent them from being able to provide information to asset managers and end-users.

The Committee passed the motion as amended.

Panel III: Discussion of the Proxy Process

Panel Presentation

Coates said the proxy system is “too complicated” due to jargon and difficult comprehension of what the proxy system does. He recommended the SEC “force” the industry for issuers and Broad Ridge, the major participant in the proxy process, to get this done. Coates said the current system does not work effectively, noting that closed votes guarantee problems. However, he said that the proxy vote process is not a priority at the time for issuers and that the SEC must intervene to apply pressure to the process. He stated the proposal suggests there be a process to reconcile problems in the voting process, with the SEC enforcing a duty for investor best interest. Coates said the proposal recommends investor anonymity with a required SEC study on the anonymous nature of contracts and whether they are objecting in the best interest of investors. He said the proposal also requires the SEC to study share lending impacts on votes and proxy ballots.

Question & Answer

Rick Fleming, IAC member, asked about objecting beneficial owners (OBO) and non-objecting beneficial owners (NOBO) changes in the proposal. Coates said that the default is for NOBO, but it is an opportunity to modify the rule based on what broker-dealers suggest, adding that this provides an opportunity to address concerns for investors that do not understand contracts and are subject to the default of NOBO. Coates said in general, a large number of brokers would preserve the anonymity of their clients from issuers because they dissent.

Verret asked about a universal proxy and a possible mandate in the proposal. Coates said the proposal is adopting the SEC’s 2016 dissident’s proposal to capture the duty to reconcile.

Allison Bennington, IAC member, made recommendations to enhance the universal proxy arguments for clarity of the two-stream ballot system and its costs.

Lydia Mashburn asked how the proposal could account for blockchain. Coates said that blockchain can be part of the process but likely not useful for data management.

Matthew Furman, IAC member, had concerns about language being too broad and suggested targeting specific instances. Coates said there are systematic problems that prevent targeted rules, and that in this proposal issuers are only required to provide investors information that is already required by law while bearing the costs.

The Committee delayed a vote on this proposal.

Panel IV: Presentation from the SEC Office of the Advocate for Small Business Capital Formation

Panel Presentations

Martha Miller, Office of the Advocate for Small Business Capital Formation, said the mission of the office is to be a resource for issue resolution, identify and offer solutions to problems, analyze the impact of proposed changes, conduct outreach, and propose appropriate regulatory small business issues. She added that the office has looked at unique areas such as diversity and inclusion and underserved areas. Miller said the office is required to submit an annual report where they make recommendations to the SEC and Congress from the prior year. She said the office makes decisions based on what the market needs, has established plans for outreach, and created a business plan as a road map to layout how the office will operate.

Question & Answer

Lydia Mashburn asked about the recommendations from outreach. Miller said there have been a few different reactions, specifically on the barriers for small business owners and investors having allies at the SEC.

Lisa Fairfax asked how the process of outreach works. Miller said developing their own brand is costly, but they have found groups with a broad reach of entrepreneurs across multiple sectors, such as trade associations, chambers, or angel investors, adding that being as accessible as possible is a major tenant of the office.

Panel V: Presentation from the SEC Office of Minority and Women Inclusion

Panel Presentations

Pamela Gibbs, Office of Minority and Women Inclusion, said the diversity of regulated entities has been the toughest task for the office to accomplish, and that with a handful of other regulators, the office focused on creating standards in 2015 to further diversity and inclusion disclosure requirements. She said that in 2018, the office surveyed roughly 1,600 entities to report their diversity and inclusion data and received 38 assessment reports that showed minority and women in place are “doing well,” though they did not get much disclosure for what positions women and minorities were employed. She said the way forward is to modify the form and repeat the survey in 2020 while maintaining confidentially.

Question & Answer

Damon Silvers, IAC member, asked how the committee can be helpful for the office. Gibbs said she has not given it thought and will have to do more research. She suggested including a provision in any human resources policy for diversity and inclusion.

Craig Goettsch, IAC member, asked about what progress regulator counterparts are making and if the study included public companies. Gibbs said the survey does not touch on public companies, but that she and her colleagues at other regulators have seen similar responses and are not getting enough to aggregate information.

Fairfax asked Gibbs to focus on workforce development and outcomes. Gibbs said that initially there was no strategic way to address workforce diversity, but her office has focused on demographics discussions, adding that the benchmark is to target the federal government, though much progress has been made in the last several years.

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