EDGAR AND FRIENDS
Go right straight down the road, to do what is best, and to do it frankly and without evasion.
Can systems of government be reformed to regain their fitness for mission? It’s far from impossible, U.S. history demonstrates. The branches of the U.S. military, for example, have needed dynamic leadership and merit-driven shake-ups to overcome periods of bureaucratic dysfunction. They have done so, particularly when national survival is at stake.
Many of us know from history courses and movies such as Saving Private Ryan about the wartime leadership of U.S. Army chief of staff General George C. Marshall and the strategy named for him of rebuilding Europe after World War II. What’s less well known is Marshall’s success as a change agent in revitalizing a moribund bureaucracy.
As historian Dwight Jon Zimmerman has written: “On September 1, 1939, Germany invaded Poland, plunging Europe into the conflict soon named World War II. On that same day, Marshall was sworn in as the fifteenth chief of staff of the U.S. Army. He assumed command of a 190,000-man force ranked nineteenth in the world, behind Portugal and ahead of Bulgaria.” As Zimmerman chronicles, President Roosevelt tasked Marshall with infusing the army with vigorous, young commanders and pruning out the careerist desk-bound officers in their fifties and early sixties, many of them aging colonels who had risen to their ranks purely on the basis of seniority. Military lore holds that Marshall kept a “little black book” during the interwar years where he recorded the names of promising officers who would be needed in the next crisis. Whether he kept the book or not, Marshall had an excellent memory for his leadership recruits that eventually included World War II’s greatest generals such as Dwight Eisenhower and Omar Bradley.
Congress cleared the way for Marshall when it passed the Second Supplemental Appropriation Act of 1940 that eliminated seniority-only promotions. Wielding congressional authority to elevate qualified officers, Marshall began his work.1
He established what he called the “plucking committee,” a panel of six retired officers. The committee reviewed older officers—particularly colonels in their sixties and near retirement who could not withstand the rigors of combat command—and got rid of many officers to create opportunities for promotions. As Zimmerman has written: “In the first six months of its existence, the panel removed 195 captains, majors, lieutenant colonels, and colonels. Ultimately 500 colonels were forced into retirement.”2 Marshall’s approach led to the military’s up or out policy where officers must meet standards to be considered for promotion over the years. If they don’t the brass reassign them or arrange for retirement.
World War II remains one of the greatest tests of national survival faced by the United States and its leaders. It required a federal mobilization program throughout civil society that would be difficult to implement in the America of the twenty-first century where consensus is so elusive. Its lessons for the untapped potential of our government agencies are important, however.
The challenges faced by the SEC since 2008 pale in comparison to the operational scope of those faced by the military and President Roosevelt in World War II. But the SEC was in a war to assure its own existence and to protect the free functioning of financial markets. Many sectors of the U.S. economy did face fundamental questions about their survival.
Mary Schapiro was charged to lead the SEC from a sleepier, clock-punching “peacetime” operation to a modernized and energetic “wartime” organization. That’s why she hired me and other veterans of the financial sector. It’s why she knew that we had to address many glaring shortcomings at the SEC including its yawning technology gap.
For too long, the SEC had practiced unilateral disarmament with its underfunded, out-of-date technology and data analysis. Systems and equipment were decades old. The agency had paid too little attention to its IT and data analytics operations that didn’t care about the SEC’s existential need to close the efficiency gap with the sector it regulated. In fact, before Schapiro, the SEC in most cases lacked the processing capacity to review and use the data it collected from the financial services industry. What’s worse, many of the SEC’s managers resisted efforts to make progress because they feared obtaining and using industry data would make the SEC liable for indicators of fraud and mismanagement in the data that they’d miss and later be blamed for. So the outdated technology systems and failure to deploy analytics reinforce one another.
Washington’s struggles with tech meltdowns such as the Obamacare website and China’s hacking of government employee information from the Office of Personnel Management (including mine!) are seen by some critics as evidence that the public sector will never work. From what I saw at the SEC, that fear is well grounded. However, I knew the application of a modicum of smarter management could make the agency work better. In the same way lax standards discourage individuals from standing out as top performers, higher standards create a space for employees with ambition and smarts to step up and do more.
THE DATA SILOS
By 2017, the SEC’s capacity and capability to analyze the data it collects and use intelligently mark one of its greatest areas of progress since the dark time of 2008. But when I first encountered SEC technology, I wouldn’t have believed that was possible. It began with a call to Doug Scheidt, IM’s chief counsel, about an issue the examiners in my group in New York found.
“Doug,” I said, “it’s Norm Champ in the New York office. We found a problem with a manager running multiple types of investment products, including funds, and not allocating opportunities evenly. It looks like they’re favoring some accounts over others, which means they’re violating their duty to some of their customers.”
The exam team and I then had a great conversation with Doug, who was very helpful. He told me I needed guidance from Enforcement, and later I decided to actually bring Enforcement staff to meetings with the fund manager in question rather than send over our whole exam file to Enforcement and hope someone got to it soon enough. We made it a regular practice to get Enforcement officials involved early when examiners found major issues so we could see if Enforcement agreed with Exam’s analysis.
But as we hung up with Doug, another concern immediately struck me. Here I was in one of the 12 SEC offices talking to Doug about an issue that came up in our region. But examiners in other regions might be seeing the same questions, and we’d never know, plus they would not have the benefit of Doug’s advice. The SEC didn’t have the tech infrastructure to do searches of internal exam reports to glean trends across regions. Examiners were like air traffic controllers who couldn’t track their jets outside of local airspace. We lacked a simple system for tracking exam red flags outside of each regional silo.
Geez, I thought, this must be pretty basic. I asked my team about it at our next Tuesday meeting.
“Guys,” I told them, “I’m finding out there’s no way for us to communicate what we learned from Doug, which was pretty darn good. We can’t capture this and spread it around to anyone else in the country. There must be a way to post exam findings online, make them searchable.”
I talked to Jim Reese, an Exam assistant director in headquarters, who along with Brian Snively, worked tirelessly to try to screen the massive data coming into the SEC to determine where examiners should look. When you entered Jim’s office in DC, you saw reams of paper with the lists of firms, and the phone rang constantly as Jim was the go-to guy for information on brokers and investment firms registered with the SEC. Jim explained that there had been an attempt to set up a system to track risks that examiners saw when they visited firms. The effort terminated when examiners input so many risks in the system that managers couldn’t draw anything meaningful from the information. I couldn’t help but think that the SEC could do better. We did have a system called STARS that tracked what exams were under way, but it contained little of substance about what the examiners found. Jim told me that the STARS system operated on outdated technology that could no longer be supported by IT and would be shut down soon.
During the national effort to resuscitate the Exam program, Jane Jarcho from the Chicago regional office emerged as a leader on improving technology for the Exam staff. Jane and a team in Chicago had an idea for a new exam tracking system that would also generate reports based on staff members’ input as they examined a firm. I hoped we could use the widely available Salesforce system when I learned that the SEC actually owned some licenses for the software (making visits to firms for exams is not that different from making sales calls). However, IT informed me that no one knew how to use the software (despite the fact that we had licenses!), and so we would have to let a consulting contract, a process that could take years. Jane and other Chicago staff forged ahead and built the system themselves. Now exam reports were online in the system and could be searched by examiners nationwide. What a huge jump from reports in paper form filed in each office and not accessible nationwide.
Someone in our weekly staff meeting suggested that we could try EDGAR to automate exam processes. Based on what I had seen of how EDGAR operated, I had no confidence in that route.
THE EDGAR MAFIA
EDGAR (which stands for electronic data gathering, analysis, and retrieval) is the SEC’s online data system for corporate and fund filings. About 4,000 staffers depend on data from EDGAR, which was state-of-the-art in 1988 but hasn’t changed much since then. While EDGAR’s antique operating system and print-only output make it extremely secure, it would have been laughed out of any private-sector operation long ago.
EDGAR and I had our awkward meeting during my first year in Exam.
One of the many Dodd-Frank rules in the SEC’s court required individuals and firms that advise municipal governments about investments to file registration papers with the agency. We searched for a system to handle these filings and considered whether EDGAR would be the one. My assistant set up a meeting with one of the EDGAR specialists, which I expected to last about half an hour. It was a little bit like the dinner party where your nephew brings all his buddies and doesn’t tell you beforehand. About 10 people showed up for the meeting, both SEC IT people and external EDGAR consultants, and filled up all the chairs in the conference room. Everyone was friendly and appropriate, all button-down shirts, polos and khakis, a scattering of white Venti Starbucks cups. A few folks took notes as I described the filing system we would like, the top manager assured me it would be no problem, and before you knew it, the entourage moved off to the next meeting.
I came to learn that like most long-running government programs, EDGAR had spawned an ecosystem that lived off EDGAR and fended off any attempts to replace it. The outdated system continues to be used and, in fact, “upgraded” at costs of tens of millions of dollars even though Google and other corporations have far more effective data storage systems. The SEC still hires numerous outside consultants to keep EDGAR running despite its tremendously outdated technology. Perhaps worst of all, different divisions in the SEC have different versions of EDGAR, one being used by Corporation Finance, one by IM, and others. All these different varieties of EDGAR had to be maintained separately, providing numerous contracts for an army of consultants while reinforcing the silo walls between divisions.
At the same time, a cottage industry of consultants outside the SEC repackaged EDGAR filings for private subscription sale.3 Even at the SEC, taxpayers ended up paying the R&D costs for more Beltway bandits to get rich. To cap it all off, EDGAR embarrassed the SEC when an outside study found that the private contractor running the EDGAR filing feed allowed traders who subscribed to get access to EDGAR filings before they posted on the SEC’s website and potentially exploit the time advantage.4 In addition, fraudsters used fake EDGAR filings to spread false reports on public companies and, presumably, to trade on such reports.5
Soon I referred to this technology-consultant complex as the “EDGAR mafia” because it was so tight-knit and resistant to change. Whenever there was a meeting with the EDGAR staff to discuss improving the system, I sat and listened as the members of this EDGAR mafia said that they could easily program whatever technological or analytical requirement we requested. However, throughout my time at the SEC, somehow all of that easy programming never happened.
FROZEN IN PLACE
As with EDGAR, the New York office’s laptops had been industry standard many years before my arrival, but they would no longer be confused even by a sixth grader for state-of-the-art personal computing technology. It was another way the SEC had been bringing the equivalent of a cavalry with spears to a twenty-first-century battlefield. This was most dramatically exposed when Dodd-Frank passed in the summer of 2010.
Dodd-Frank reregulated the entire securities industry, so the SEC had a ton of new rules to write (remember, regulators write the rules that figure out all the details for how each provision of a law will be carried out). The proposals for new rules ran into the hundreds of pages each, usually at least 800 pages. As the head of the policy effort for Exam, I regularly reviewed the draft rule proposals and worked with my indispensable partner Judy Lee to give feedback based on the input of the expert examiners. There was one big problem. The technology system in New York couldn’t handle that many pages. The laptops we used as desktop computers were so underpowered that my system crashed the minute a long release arrived by e-mail. The frustration of tapping keys while your screen refuses to change a single pixel can make the most even-keeled managers grind their teeth.
It took me a while to figure out that the long release drafts were causing the computer to freeze up and crash. The urban legend held that during some prior regime, management ordered that the laptops have the least amount of memory possible to save money. I don’t know if that was true, but I do know that the SEC had laptops that couldn’t even handle an everyday task such as rule writing—or even e-mail storage, as we learned in Chapter 3.
Despite these storage shortcomings, in New York my personal computer did work from day one. I was impressed by our regional head of technology, an incredibly talented guy named Ed Fallacaro. Ed had managed technology in the private sector, and he knew how to make stuff work. Ed was commuting to work in New York from Philadelphia. Even with that terrible schedule, he managed to run an excellent IT function in New York. Ultimately, he got hired in the Philadelphia SEC office to be the regional managing executive. I know that Philadelphia management was thrilled to have him, and he was doing a great job when I left.
BATTLING BACK
None of this was lost on Schapiro as she fought to upgrade the SEC. In 2010 she hired Maris Technology Advisors’ CEO Tom Bayer as her chief information officer,6 and she pushed for funding for the SEC’s technology budget in the Dodd-Frank Act. She charged Bayer with modernizing and transforming the SEC’s infrastructure and data processing, and over his four-year tenure Bayer made good progress. Tom moved the SEC to cloud-based data storage and computing capacity and, in my view, stepped up the professionalism of the IT function.
Tom called soon after he started and made an appointment to see me in New York. When he called, I wasn’t exactly sure who he was, but just a few minutes into our meeting, I realized he was an ally who didn’t think much of EDGAR either.
Tom’s hiring was the first step. Schapiro and the commissioners lobbied hard during the debate over what would become Dodd-Frank to allow the SEC to set its own budget instead of Congress deciding its budget despite the fact that the SEC was largely self-funded through industry fees.
Schapiro argued that the agency found it extremely difficult to establish and fund priorities when appropriations fluctuated so much each year based on political considerations in Congress. This argument was particularly powerful in the area of technology, where both poor management within the SEC and the constantly changing budget meant that long-term technology projects were extremely difficult to establish, maintain, and fund. In practice this meant that as the SEC lurched from one technology project to the next, the project would either get delayed, canceled due to lack of funding, or ultimately forgotten in the mishmash of spending on technology. As Schapiro testified in June 2009 (and would testify in similar terms again):
I believe additional resources are essential if we hope to restore the SEC as a vigorous and effective regulator of our financial markets. . . .
Although expanding our workforce is a critically important step, I believe we also must give our staff better tools to conduct oversight of vast financial markets. That is why the President’s request for FY 2010 also contains funds for additional investments in our information systems. Investments in new systems have dropped by more than half over the last four years, and as a result the SEC has a growing list of technology needs that have gone unfunded. . . .
The SEC also plans to improve our ability to identify emerging risks to investors. We have many internal data repositories from filings, examinations, investigations, economic research and other ongoing activities. But the SEC needs better tools to mine this data, link it together, and combine it with data sources from outside the Commission to determine which firms or practices raise red flags and deserve a closer look.
Finally, we would invest in our multi-year efforts to improve the case and exam management tools available to our enforcement and examination programs. These systems would give our senior managers better information on the mix of cases, investigations, and examinations, so they can apply resources swiftly to the continually evolving set of issues and problems in the markets. In addition, these tools will provide better support for line staff in these programs, so they can be more productive and better able to match the sophisticated systems used by the financial industry.
Schapiro hammered this message every time she could, and she got a bigger budget. The advocacy began to work. It improved our ability to do a number of things during my years of service to upgrade the SEC’s capacity to understand and use its storehouse of data about financial firms.
Show Me the Numbers First, we stopped making things up when it came to writing policy rules. Schapiro and chief economist Craig Lewis published a document that laid down the law. It required that SEC policy experts use real-world economics to show how a new policy would affect investors, consumers, and businesses. For a policy to be adopted, the officials writing it had to show an understanding of the risks and an analysis of the financial consequences—a kind of economic impact statement.7 I was thrilled because this was a check against the power of anyone—commissioners, directors in IM or any other division—deciding on his or her own the direction of financial regulations in the United States. Requiring that regulators run the numbers makes an effective balance against officials making policy based on their own views.
One problem: This slowed down analysis of market risks because the Economic and Risk Analysis division now had to perform more work to sign off on the economic impact of a rule. When new policy documents started going through the door at that division it meant that analysis of industry data to spot risks slipped lower on the priority list. Schapiro’s directive was brilliant for policy making but diverted economists’ resources away from analyzing data both to help Exam know where to look and to help IM and the other policy divisions identify emerging risks. For Carlo di Florio and me, even before this development, we weren’t going to wait.
We saw the opportunity to strengthen and mobilize Exam’s own Risk and Surveillance Unit. We started collecting our own data from field audits and doing our own risk reports. We bulked up Jim Reese’s staff and harnessed data to identify risky firms for examination. Soon other divisions followed suit—including IM later on under my leadership when we formed the Risk and Exam Office. In some ways, this looked like the duplication of services that drives people including me crazy about the SEC. But the satellite units helped keep the agency looking out the window at the real-world trends in the financial industry.
Secret Meetings Sharing data and information across tech silos was sometimes easier than doing so across human ones. Here’s an example of how old-school intel sharing should work, where government operatives working toward the same goal trade information, but in this case did not.
While I was in the hedge fund business, I sat down quarterly with two SEC staff members from the Division of Trading and Markets about observations on the market. It was a good idea on their part. Why not learn more about the hedge funds that are the big customers of broker-dealers such as Goldman Sachs that Trading and Markets regulates? Hedge funds had billions of dollars of securities held by those brokers.
After I started at the SEC in January 2010, I ran into one of those Trading and Markets guys in the hallway, and the lightbulb went on over my head. I fast-walked back to my office, thinking “Great idea, Norm!,” got a meeting set up, and sat down with him and his partner later that week.
“Hey, you know I really enjoyed meeting you guys when I was on the outside,” I told them.
“You, too, Norm; we really enjoyed it!” they chimed back, relaxed, even a smidge jovial. To me, the subtext was “It’s Norm the new guy. My fresh coffee’s hot, and he’s not a problem.”
And I didn’t want to be one.
“Now I am in charge of Exams,” I went on. “By the way, I am a little nervous because there are a lot of firms that haven’t been examined. I have this list of hundreds of firms that we could examine, but I could use your help to decide where to send my examiners.”
I continued, “Listen, you’re out talking to hedge funds all the time. Do you see any red flags in any of them? Do you see any hedge funds you think may be superaggressive? Do you see any that you didn’t think had great internal controls, anyone that said anything that might worry you? Let’s talk. Tell me who those might be. Then I can go out and examine them.”
A long pause.
“Well . . . uhhh . . . what do you mean?” they asked. Less jovially.
“You’re out at hedge fund firms. I was in one for a number of years, and I am involved in the industry, so I have some view of the whole industry. But you guys are Trading and Markets. You are going and visiting a bunch of hedge funds. Were any of them you thought better than others? Were any of them worse than the others? Were there any that were riskier? I am after some color so I know where to send my examiners.”
They explained that they didn’t write anything down.
I said, “Do you have a report on these people?”
“No.”
“Do you have any sense about any of them?”
“No.”
“Well, do you have a report or something you can put out about them?”
They repeated that they never generated anything like that.
For the next 2½ years I never got any information from these guys about the funds they met with, and I could never get a straight answer about why I didn’t get the information. We all worked for the U.S. government, and we were there to fulfill the agency’s mission, and yet they wouldn’t share the most basic information with examiners.
I saw that my two friends did a lot of good work. But they didn’t budge on this one, nor at first did senior leadership in Trading and Markets. Why? Perhaps they thought that if they gave information to us that they learned from speaking with hedge funds or, for that matter, included Exam in conversations with the brokers they regulated, the hedge funds and brokers would clam up and no longer be candid with them. I didn’t view it that way, of course. My friends were taking a huge risk if they believed they were having off-the-record conversations with these firms. First of all, nothing in this world is off the record anymore. Second, if my friends learned about wrongdoing at a firm and didn’t follow it up, their own careers would be in jeopardy. We all took the oath that I reproduced in Chapter 2 requiring us to faithfully discharge the duties of our offices, including investigating any irregular or potentially illegal actions. If you see something, yes, you say something.
But my two Trading and Markets friends knew I knew that busting fund managers wasn’t the purpose of their meetings. I later confirmed in my own get-togethers with top broker-dealer and fund managers that people at these firms know the laws and rules, aren’t planning on breaking them, and definitely wouldn’t in front of you. So they’re happy to learn from the SEC and vice versa. But they cannot be told that the conversations are “off the record.” No such thing.
Arming IM with Analytics It wasn’t until I took over IM in 2012 that I’d face the most resistance in carrying out Schapiro’s call to become “more productive and better able to match the sophisticated systems used by the financial industry.” IM was at a great disadvantage in the SEC’s dealings with the Fed and its analytical firepower. The Fed used its deep bench of economists and analysts to trample over the views of the SEC on policy disputes.
I learned from my time in Exam that IM lawyers weren’t that informed by industry data Exam had when they wrote rules. (I also found out they didn’t want too many inquiries from the public and industry because IM’s website featured instructions in blaring font for every type of website visitor to contact another division of the SEC—anyone but IM! Fortunately we fixed this.)
The SEC’s examiners appreciated the data findings from Exam’s Risk and Surveillance group because they became tools to point them toward trouble spots, to find the securities firm needle in a haystack that most warranted attention.
But the silo between Exam and IM as well as Exam’s structure blocked examiners from sharing data found in their exams with the policy makers in IM. No mechanism existed for Exam to convey its findings to rule makers in IM. This left staff members at IM writing rules based partly on their own views and meetings with consumer activists or industry lobbying groups. This opened them to the real risks of helping carry out interest-group agendas without giving due consideration to the impact of their decisions on investors whose well-being we swore to protect. Without data, regulators lacked objective criteria for highlighting risks that required action and tended to revert to their own long-held views. IM was like the Oakland A’s without Billy Beane or a cargo ship without a navigation system—hoping the old scouts and salts knew best.
I needed a better way for IM to understand what was happening in the industry. We didn’t have an office or specialists dedicated to industry intelligence or analysis. So I decided in the fall of 2012 to see what industry data materials we might have that had been overlooked. I took a look at the division’s Disclosure Review Office.
The 60 attorneys in disclosure review spend their days evaluating hundreds of filings by mutual funds each year to make sure that the disclosure in fund documents is adequate for investors to understand. For instance, if a fund manager does not state exactly what investment strategy the fund will pursue, the lawyers in the group will return the document and ask for changes to be made.
The disclosure attorneys sat at their terminals wading through a blizzard of documents that never stopped piling on. I’m sure after a while it wasn’t good for their mental health. They were dedicated public servants doing work that had to be done, and their diligent reviews weren’t being utilized effectively.
They lacked any tools to manage how they reported their findings. The laws required that the disclosure office gather and publish their comments on the filings so future filers could see the correspondence. But none of that could be automatically done in EDGAR or a shared server workspace as basic as a G-drive. It wasn’t like the lawyers were writing up the comments in calligraphy on parchment—but it was close. The reviewers sent in their comments to one poor sod who had the job of assembling the comments via cut and paste into a document that was uploaded to the EDGAR system. If this person took a long vacation or went on sick leave, the public postings fell months behind. Fortunately, my predecessor Eileen had reassigned some folks to help the disclosure office catch up, but it was hardly a solution. Happily some of the paralegals that Denise Green obtained from Enforcement helped shoulder the burden of publishing the comments.
I realized the filings offered a vital stream of information about newly launched funds, their strategy, and their operations that none of us were tracking. So I sat down with Barry Miller, the head of the office.
“We’re seeing the development of the industry through these filings,” I said. “I’ll bet we can mine them for trends and hot spots. You know, are there more of certain kinds of filings? Are there issues with disclosures? What fees are you trying to get people to disclose that they don’t want to disclose?”
Barry told me that disclosure didn’t keep anything like that. I remember Barry saying. “We have so many filings.”
“The attorneys don’t need to reexamine every filing,” I said. “We can use triage and spend more time looking at amendments because the registrant actually has to say in the amendment filing if there is a material change or not.”
“We don’t have to take Vanguard’s word every time,” I continued. Maybe we will take Vanguard’s word 99 out of 100 times. We will sample a filing and make sure that the fund is telling the truth. It could be a start.”
Barry went away, and he talked to a lot of his people. When he came back to me, he related that they found an uptick in managers’ filing papers for “alternative” mutual funds that market themselves as pursuing hedge fund investing strategies. In fact, the growth was big—from zero to more than 30 percent of new inflows in one year.8 These funds gave the ordinary investor access to the riskier, “hedging” strategies used by the likes of John Paulson without needing the $5 million to invest that his fund requires. We highlighted this filing trend at the SEC Speaks conference in early 2013 well before the financial press noticed the trend in these filings. Since hedge funds often pursue strategies involving illiquid securities, I gave several speeches emphasizing that these new funds would have to be able to redeem investors on a daily basis as required by the law.9 This became our first effort at capturing industry information on a systematic basis for use by the policy makers at IM and the SEC in general.
It was an example of what IM could do with the most rudimentary considerations of the data that was passing right under our noses. And a refutation of the fear that it’s not worth it. To institutionalize the effort of gathering data from the filings, we assigned Mike Spratt, the talented IM lawyer who had come back from a commissioner’s office, to compile data on filings on a routine basis in order to inform the division.
Closing the Quant Gap As we were ramping up our disclosure office operation in the fall of 2012, I decided to ask my team: Where are the examiners? Dodd-Frank, the sweeping national law reconfiguring the entire financial industry, said IM must hire its own examiners—a sound policy.
Remember that by 2012, IM had only hired one analyst, two years after the law ordered them to. Someone said to me, “Oh, we haven’t done much about it.”
I fumed a bit. I had to stare out the window to go to my Zen place. Congress told us to hire examiners, and we haven’t done anything?! If I am asked about this during a hearing up on the Hill, it will get ugly. What’s worse, we’re wasting an opportunity to continue to modernize.
I also didn’t see the value of hiring a few examiners to replicate what Exam was doing with 450 investigators looking at investment firms. IM’s people needed better processes to work with the entire Exam Division. I feared having a few examiners down the hall would become an excuse for folks to stay in their silo. I chewed it over with my team, and we gave the whole situation a few days. What we did next became one of those very few times in life that I had an idea that took off right away and worked beyond expectations.
I put together a proposal to start a Risk and Examinations Office (REO) in IM and recommended that we hire Jon Hertzke to run it. Mary Schapiro approved it immediately. We chartered REO, as the SEC’s website says, to monitor industry trends, manage and analyze industry data, and gather and analyze operational information from the asset management industry, including “the risk-taking activities of investment advisers and investment companies.”
So we went out and recruited data analysts and quants (such as a risk manager from BlackRock and two science PhD holders) who know how deal with massive amounts of data and tell you what it means. We hired some traditional examiners, too, because I wanted to be able to go to Congress and tell them that I had examiners. But we used those examiners in a much different way. We used them more to find something out for the policy writers rather than to check on firms’ compliance.
One early example of the role of these new examiners: we wanted to understand how firms value the securities held in their funds, which is the basis for calculating NAV (which we discussed in Chapter 6). So we took the REO examiners and sent them out to collect valuation policies from different firms. If you need to know something from a policy perspective, they can go do it. We even had the REO examiners piggyback on exams of firms that Exam was already conducting so that our data gathering efforts were invisible to the industry. We ended up hiring about 20 experts in the office.
Having the new office turned out to be exquisitely timed and perhaps saved the SEC from being relegated to the second tier of regulators. In 2013 and 2014, a number of crises rocked the United States markets. The Puerto Rican debt crisis surfaced, Russia invaded Ukraine, and the Nasdaq went dark off and on for two days.
We sicced our team of quants on all these issues. In years previous the government’s pressure for answers would have forced SEC leaders into a defensive crouch, such as during the 2008 money market fund crisis when IM could not provide any real-time analysis. Now we had a math geek squad of our own that helped us anticipate questions such as if Puerto Rico is going to default on its debt, what does that mean for the many muni bond mutual funds that own bonds issued by Puerto Rico?
A number of financial executives and media appreciated that we had these new assets. But that didn’t stop the star chamber at FSOC from attempting a takeover of the SEC’s core function. In September 2013, FSOC’s Office of Financial Research published a report, “Asset Management and Financial Stability,” that was essentially an act of war against the SEC.10
The report announced that FSOC thought the investment management industry was too risky and should be regulated like banks by FSOC instead of the SEC. This was the bureaucratic equivalent of the U.S. Army trying to take over the U.S. Navy’s ships.
The commissioners and many others at the SEC started to freak out. Commissioner Michael Piwowar gave a number of speeches taking on FSOC that were characteristic of how SEC commissioners and leaders felt. In a chamber of commerce speech in January of 2014, Piwowar said:
The second threat to our core mission is banking regulators trying to impose their bank regulatory construct on SEC-regulated investment firms and investment products. Yet the Commission—not the banking or prudential regulators—is responsible for regulating markets. My concern is that the banking regulators, through the Financial Stability Oversight Council (FSOC or Council), are reaching into the SEC’s realm as market regulator. . . .
The FSOC, within which the banking and prudential regulators exert substantial influence, represents an existential threat to the SEC and the other member agencies. Last September, the Department of Treasury’s Office of Financial Research (OFR) published a study—and I use the term “study” loosely—prepared for the FSOC on the asset management industry. The study sets the groundwork for the regulation of asset managers by the FSOC. . . . I vehemently believe that before the FSOC decides whether further study or action is warranted, the collective voices of the public and the SEC should be heard by the members of the Council. This is all the more important because the vast majority of asset management firms are SEC-regulated entities.11
Piwowar argued that the bank regulators had three seats at FSOC (Fed, OCC, and FDIC), and the SEC had only one; what’s worse, the banking members restricted meeting attendance to maintain control of FSOC: “One of the responses I received to my request [to attend] was that, if the SEC started bringing multiple people to the Council meetings, then every agency would want to do the same. My answer to that concern is that the FSOC should get a bigger table.”
Later in 2014 at the American Enterprise Council, Piwowar said the FSOC releasing its own recommendations on money market funds—including instituting capital requirements similar to what banks face in order to prevent investor panics similar to bank runs—was “the most obvious example of the Council’s much-discussed hubris.” He said his complaints about the FSOC made “the Colonists’ 27 grievances against King George III and Martin Luther’s 95 Theses protesting clerical abuses seem remarkably terse.”12 Among the terms Piwowar used to describe FSOC during the speech included “the firing squad on capitalism,” “the bully pulpit of failed prudential regulators,” “the Dodd-Frank politburo,” and the “unaccountable capital markets death panel.”
Could this have been the end of the SEC as we know it? Even worse, were we witnessing a federal government takeover of America’s investment sector!? As we’ve shown, FSOC was driven by bank regulators who distrusted the risk-reward trade-offs that characterized investing in mutual funds, the stock market, bonds, and other instruments.
But Jon Hertzke and his quants in REO and the IM rule-making staff, along with economists Christof Stahal and Giulio Girardi from Craig Lewis’s Division of Economic and Risk Analysis, saved the day. FSOC formed staff working groups to look at designating Fidelity and BlackRock as “too big to fail,” and I insisted that our staffers be on the working groups. Our quants and lawyers provided the data showing that these two firms did not present significant risk because they managed money based on investor mandates for their funds. Each time an FSOC official would say to me that if these firms sold all their securities, the markets would crash, I responded that these managers had a legal obligation to invest in the securities stated in their fund documents. Selling everything violated that obligation. One frustrated FDIC official finally said to me, “I don’t care about the facts of how they work. I want to designate a few.” At least he was honest.
IM’s team shredded FSOC’s dangerous arguments that American investors couldn’t handle the risk of open markets. We argued that forcing mutual and hedge funds to eliminate risk to investors by running only highly conservative, low-return funds would cost far more in U.S. and global job creation, wealth creation, and productivity than would be gained by minimizing investor losses through market cycles. The squabbles with FSOC continued through 2014, but their attempt to capture these two firms ultimately fizzled out because our SEC was getting stronger and faster to respond. In Chapter 9, I’ll share the interesting conclusion to this part of the SEC’s continuing existential war with FSOC.
Fortunately the SEC finally had started to understand the power of big data and how to use it. The financial media began to notice our defense against FSOC.13 We were a littler meaner and leaner. We were getting more comfortable standing up to the FSOC star chamber and fighting for the core mission of the SEC. Our newfound confidence would be needed as we tackled the next big challenge—making sure the Volcker Rule for banks didn’t wipe out vital risk taking in U.S. markets.