From 1933 to 1934, Senator Ferdinand Pecora, the senior lawyer for the Senate Banking Committee, led an examination into securities market abuses that inspired the regulatory framework set out in the Securities Act of 1933 and the Securities Exchange Act of 1934. The legislation noted the predatory practices that motivated its consideration and adoption:
“Alluring promises of easy wealth…freely made with little or no attempt to bring to investor’s attention those facts essential to estimating the worth of any security. High pressure salesmanship rather than careful counsel was the rule in this most dangerous enterprise.” H.R. Rep. No. 85, 73d Cong., 1st Sess. 2 (1933).
More than seventy years later, as the Financial Crisis Inquiry Commission begins to hold hearings to unravel the causes of the recent financial crisis, Congress again takes up the task of addressing the accuracy of disclosure regarding valuation of complex financial instruments sold to the public (pension funds and other institutional investors). Throughout the hearings, we can anticipate accusations of greed and retorts equating greater federal government intervention with paternalism. As regulators, independent experts and senior management of the largest financial services firms arrive in Washington DC, however, we should take this opportunity to consider carefully the broader weaknesses in the structure and substance of federal securities market regulation.
The testimony solicited publicly and privately prior to the commission’s inaugural meeting suggests that disclosure will present a critical point of departure for inquiries about the recent crisis. For example, Congress is likely to challenge the practices of banks that sold clients financially engineered products like collateralized debt obligations which involve the sale of interests in bundles of residential and commercial mortgages. While the same banks encouraged credit rating agencies to assign strong, positive ratings to these products to increase revenues, they contemporaneously entered into short position contracts on these investments which rewarded the banks when the CDOs declined in value.
While important, questions or legislation focused exclusively on increasing the quality and quantity of disclosure are myopic and solutions arising out of this approach will prove insufficient to address broader market concerns. Questions or legislation should also address financial innovation or the development of new financial products or uses of products or processes not previously available and the ethical obligations of the firms that develop and distribute these products, the fragmentation among securities market regulators and the absence of consistent, effective inter-agency collaboration and the influence of international economic interdependence and regulatory competition on the development of U.S. regulation and the regulation in foreign jurisdictions. As often is the case in the securities regulation debates, there are many challenging questions and far too few effective answers.