President Barack Obama appointed Mary Shapiro Chairwoman of the Securities and Exchange Commission at the same time as he appointed other key financial regulators, demonstrating the importance of this post in the context of Wall Street’s financial meltdown.

Ms. Shapiro was promptly confirmed by the Senate Banking Committee, and took office on Jan. 27, 2009. A more qualified chair of the SEC would be difficult to find. In addition to having been a former SEC Commissioner, she is a former chair of the Commodity Futures Trading Commission (“CFTC”) and the immediate past CEO of the Financial Industry Regulatory Association (FINRA). She is smart, politically savvy and determined. She always has succeeded in her past regulatory roles. Nevertheless, the challenges now confronting the SEC are so daunting in this 75th year of the agency’s existence, that some wonder whether the SEC will survive as an independent agency.

In the waning days of the Bush administration, the SEC was attacked by both the left and the right for failing to prevent the collapse of broker-dealer holding companies, for failing to uncover the Bernard Madoff Ponzi scheme, for repealing the up-tick short sale rule, and for other real and perceived failings.

I have previously argued that the SEC was unfairly fingered in this blame game, and that in my view the primary cause of the current financial crisis was an overly leveraged economy and financial system, which sowed the seeds for speculative markets over which the SEC was without authority to control. 1 Serious gaps in financial regulation were recognized by the SEC, but Congress failed to plug these regulatory holes.

But whether and how much the SEC is to blame for the current pain felt by investors is beside the point. Trust in financial regulation by all financial regulators, including the SEC, needs to be restored in order for the financial markets to recover and for investors to put their savings into stocks and bonds.

The SEC’s mandate has never been to prevent the stock market from falling, and in the past, no broker-dealer was considered too big to fail. If an investment bank mismanaged its business, it was forced into bankruptcy. The securities laws were designed only to protect customer funds and fully paid for securities held by brokers as custodians. In 2008, the Federal Reserve Board and the Treasury decided that the option of bankruptcy for some large investment bank holding companies was no longer good policy. If that is to remain the case, broker-dealer holding companies should be regulated like other financial players considered too big or too interconnected to fail, but this is essentially utility regulation.

Leverage and risk-taking will have to be severely curtailed. This may be the proper regulation for commercial banks, but it may not be the best regulation for investment banks over the long term, since they are supposed to act as underwriters of risk in the capital formation process and as traders of securities in the secondary markets for price discovery and liquidity objectives.

Although there seems to be a growing consensus that such prudential regulation should be assumed by either the Federal Reserve Board or a new prudential regulator, rearranging the regulatory chairs is not as important as changing the substance of the net capital rule applicable to broker-dealers. Risks to the whole enterprise, and not just risks to the broker-dealer entity need to be taken into account in any capital adequacy rules. There is a serious question as to whether assuming the role of a prudential regulator for all large financial institutions should be placed in the hands of a central banker because of the serious conflicts of interest involved.

The Department of the Treasury is a political executive branch department. So the question of how prudential regulation should be administrated and by whom is not a simple one to answer, especially if one believes such regulation should be entrusted to an independent agency.

There is widespread agreement that over-the-counter (OTC) derivatives should no longer be exempt from regulation, but what role the SEC should play with regard to their regulation is unsettled. Should these instruments be regulated as securities by the SEC, or as financial futures by the CFTC, and how can the transparency which is needed for their regulation be accomplished? The role of the SEC in regulating hedge funds and credit rating agencies (CRAs) is similarly to be determined.

Both the SEC and the CFTC should be given more workable statutes and be made freer from industry and congressional interference. Although the SEC is “independent” of the executive branch, it is not independent of Congress, and is not sufficiently large, well-funded or protected by powerful political forces, particularly after the financial crisis for which it is being blamed, to operate as the expert regulator it was intended to be.

The day after Mr. Obama’s inauguration, the Government Accounting Office (GAO) released a framework for assessing financial regulatory reform proposals. 2 One of the most important points made in this framework is that “[r]egulators should have independence from inappropriate influence, as well as prominence and authority to carry out and enforce statutory missions.” 3 The SEC needs new authority and greater funding in order to regulate important unregulated sectors of the securities markets such as credit derivatives and hedge funds. Regulation of other sectors, including credit rating agencies and investment advisors needs to be seriously strengthened. These tasks cannot be accomplished under a barrage of criticism from a Congress trying to deflect blame from its own failings.

One of the most important messages of the financial meltdown is that OTC derivatives are dangerous securities and should never have been allowed to be wholly unregulated. Battles between the SEC and CFTC began almost as soon as the CFTC was formed in 1975 because shortly thereafter the Chicago Board Options Exchange introduced the first futures contract on a security. 4

Distinguishing between a commodities futures contract and a security was always difficult, and protecting jurisdictional turf frequently seemed more important to the SEC and CFTC, and their respective congressional oversight committees, than did protecting investors.

Such competition is ongoing despite the financial crisis it helped to engender. The competition between the SEC and the CFTC was resolved to some extent by the Commodity Futures Modernization Act of 2000 (“CFMA”), 5 which permitted commodities exchanges to trade single stock futures. Unfortunately, the CFMA also legislated that the trading of OTC financial derivatives between sophisticated counterparties should be excluded from regulation by the CFTC, the SEC or anyone else. 6

Although there is something of a consensus on the need to regulate OTC derivatives, there is not at this time a consensus on whether the SEC or the CFTC or both agencies or neither agency should regulate these instruments, or how they should be regulated. Some believe that the key to regulating OTC derivatives is to force them to be traded on exchanges; some believe the key to regulating them is to force them to be cleared by regulated clearinghouses. It can be anticipated that the derivatives industry will resist whatever new regulation is proposed, and that those who believe systemic risk is the problem posed by OTC derivatives will argue that the Federal Reserve Board or some other agency devoted to prudential regulation should oversee this market. These discussions are likely to lead to the issue of whether the SEC and the CFTC should be merged, and if so, how their respective statutory mandates should be melded with respect to market regulation.

Hedge Funds

Ever since hedge funds became participants in the securities markets, in the 1950s, they have endeavored to operate as unregulated entities and the SEC has been uncertain about how, if at all, to regulate them. Most hedge funds in the United States are formed as limited partnerships in order to obtain flow-through tax treatment. Although most hedge funds and private equity funds meet the definition of an investment company as being “engaged primarily . . . in the business of investing, reinvesting, or trading in securities,” 7 they fall within exceptions to that definition either because their securities are owned by not more than one hundred persons or their securities are owned “exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers,” and they are not making or proposing to make a public offering of their securities. 8

Similarly, the manager of a hedge fund or private equity fund falls within the definition of an investment advisor as “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing or selling securities.” 9 However, an exemption from registration as an investment adviser exists for the small advisor who has had fewer than 15 clients, does not hold himself out generally to the public as an investment adviser, and does not act as an investment adviser to any registered investment company. 10

The key to the long-time exemption for hedge funds and other private investment funds doing business as limited partnerships was that the managing partner was considered to have only one client – the limited partnership. 11 This safe harbor was adopted in 1985, 12 but the SEC attempted to eliminate it by a rule changing the definition of the term “client,” so that each shareholder or beneficiary of a private fund would be considered a separate client in counting the 15 clients for an exemption under the Investment Advisers Act. 13

There were two dissents to the promulgation of this rule, 14 and the rule was struck down by the Circuit Court for the District of Columbia in Goldstein v. SEC, 15 as beyond the authority of the SEC. This situation became a challenge to the SEC and Congress to decide whether the securities laws needed to be amended to give the SEC authority to regulate hedge funds.

This challenge was recently taken up by Senators Charles Grassley and Carl Levin who have introduced “The Hedge Fund Transparency Act,” which would give the SEC the authority to regulate all pooled investment vehicles, including hedge funds, which manage at least $50 million in assets as investment companies. This is a different and potentially much broader authority than the SEC sought in its rulemaking. Whether such a bill would become law, however, is up in the air, since Congressman Barney Frank has spoken about drafting a bill for a new prudential regulator, which, among other things, would be given the responsibility for regulating hedge funds. 16

Credit Rating Agencies

Focus on the role and appropriate regulation of CRAs has been ongoing in the United States and abroad since at least the collapse of Enron since until four days before Enron declared bankruptcy, major CRAs continued to rate its debt as “investment grade.” 17

More recently, criticism of the conduct and competence of CRAs has focused on the huge number of write downs of previously highly rated residential mortgage-backed securities and collateralized debt obligations in the context of the sub-prime mortgage crisis. 18

In 1975, the SEC adopted the term nationally recognized statistical rating organization (“NRSRO”) to determine capital charges for broker-dealers for purposes of the SEC’s capital adequacy or net capital rule. Marketplace and regulatory reliance on credit ratings then gradually increased, and the concept of an NRSRO became embedded in a wide range of U.S. regulations of financial institutions, as well as state, federal and foreign laws relating to creditworthiness.

Congress passed the Credit Rating Agency Reform Act (CRA Reform Act) in 2006, which established a system of registration and regulation of NRSROs and instructed the SEC to formulate implementing rules. 19

In June 2007, the SEC passed rules implementing the CRA Reform Act, which set forth basic registration requirements for NRSROs; subjected NRSROs to recordkeeping and annual financial registration forms; established procedures to prevent the misuse of confidential information and to manage conflicts of interest; and prohibited certain anti-competitive or abusive practices. 20 Further rules were adopted in December 2008. 21 Among other things, these rules require NRSROs to disclose their procedures and methodologies in determining credit ratings for structured finance products and other debt securities and to make publicly available a random sample of ratings histories of credit ratings paid for by the obligor of a credit. It is reasonably certain that these rules do not meet all of the political and market needs contemplated by the CRA Reform Act, as a number of ideas proposed by the SEC in June were left hanging, and have been re-proposed. 22

Are the Obama administration, the SEC and Congress up to meeting all of the new challenges discussed in this column, as well as many other challenges on the table of financial regulatory reform? History teaches that most regulatory reform has occurred in an atmosphere of crisis and scandal, but that statutes drafted under such conditions are neither thoughtful nor even coherent. Hopefully, the new chairman of the SEC will be able to exert a salutary influence on such legislation.

Roberta S. Karmel is Centennial Professor of Law and Co-Director of the Dennis J. Block Center for the Study of International Business Law at Brooklyn Law School. During Winter quarter 2009, she is the Harry Cross Visiting Professor at the University of Washington School of Law.

1. See Roberta S. Karmel, The Blame Game, NYLJ, Oct. 16, 2008; Roberta S. Karmel, Focus on Credit Rating Agencies Post-Subprime Meltdown, NYLJ, Aug. 21, 2008; Roberta S. Karmel, Financial Regulatory Reform Ideas, NYLJ, June 19, 2008; Roberta S. Karmel, Speculation and Leverage, NYLJ, April 17, 2008.

2. GAO, Financial Regulation – A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System, Jan. 21, 2009, GAO-09-314T.

3. Id. at 4.

4. See Jerry W. Markham, The Commodity Exchange Monopoly – Reform Is Needed, 48 Wash. & Lee L. Rev. 977, 985-97 (1991).

5. Pub. L. No. 106-554, 114 Stat. 2763 (2000).

6. Department of the Treasury, Blueprint for a Modernized Financial Regulatory Structure (March 2008),, at 47.

7. Investment Company Act §3(a)(1)(A), 15 U.S.C. §80a-3(a)(1)(A) (2008).

8. Id., §§3(c)(1), (7), 15 U.S.C. §80a-3(c)(1)(7) (2008). For this purpose, a “qualified purchaser” is a natural person who owns not less than $5,000,000 in investment securities. Id., §2(a)(51)(A), 15 U.S.C. §80a-2(a)(51)(A).

9. 15 U.S.C. §80b-2(a)(11).

10. 15 U.S.C. §80b-3(b)(3).

11. 17 C.F.R. §275.203-(b)(3)-1 (2008). The safe harbor provided for in this rule would also apply to private funds doing business as corporations, LLCs or trusts.

12. Definition of “Client” of an Investment Adviser for Certain Purposes Relating to Limited Partnerships, Investment Advisers Act Release No. 98350, Fed. Reg. 29206 (July 12, 1985). The initial safe harbor was an effort to clarify that a general partner to a limited partnership was advising the partnership and not the partners individually.

13. Registration Under the Advisers Act of Certain Hedge Fund Advisers; Final Rule, Investment Advisers Act Release No. 2333, 69 Fed. Reg. 72055 (Dec. 10, 2004). Private equity and venture capital funds were exempted.

14. Id. at 72089 (commissioners Glassman and Atkins, dissenting).

15. 451 F.3d 873 (D.C. Cir. 2006).

16. See Kara Scannell, Frank Backs Regulator for Systemic Risk, Wall St.J., Feb. 4, 2009.

17. Claire A. Hill, Regulating the Rating Agencies, 82 Wash. U.L. Q. 43 (2004).

18. See Proposed Rules for Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 57967, 73 Fed. Reg. 36212 (June 25, 2008), at 36216-18.

19. Pub. L. No. 109-291 (2006).

20. 17 C.F.R. §§240.17g-2-g-6.

21. Amendments to Rules for Nationally Recognized Statistical Rating Organizations, Exchange Act Release No. 59342, 74 Fed. Reg. 6456 (Feb. 9, 2009).

22. Re-proposed Rules for National Recognized Statistical Rating Organizations, Exchange Act Release No. 59343, 74 Fed. Reg. 6485 (Feb. 9, 2009).